**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM 10-Q**

 

| **(Mark One)**                                                                                                                                        | ** ** | ** **                                                                                          |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                            | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**   | ** ** |
| ** **                                                                                                                                            |       |                                                                                                |   |
| **For the quarterly period ended June 30,  2004**                                                                                                |
| ** **                                                                                                                                            | ** ** | ** **                                                                                          | ** ** |
| **OR**                                                                                                                                                |
| ** **                                                                                                                                            | ** ** | ** **                                                                                          | ** ** |
| **o**                                                                                                                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** | ** ** |
| ** **                                                                                                                                            |       |                                                                                                |   |
| **For the transition period from            to           ** |

 

**COMMISSION FILE NUMBER 000-29661**

 

----

 

**UTSTARCOM, INC.**

(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                                                                       | ** ** | **52-1782500**                       |
|------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State of Incorporation)                                                           |       | (I.R.S. Employer Identification No.) |
| ** **                                                                         | ** ** | ** **                           |
| **1275 HARBOR BAY PARKWAY  ALAMEDA, CALIFORNIA**                                   | ** ** | **94502**                            |
| (Address of principal executive  offices)                                          |       | (zip code)                           |
|                                                                               |       |                                 |
| Registrant’s telephone number, including  area code:  **(510) 864-8800** |

 

----

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes   ý  No   o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act of 1934).  Yes   ý  No   o

 

As of June 30, 2004 there were 113,912,641 shares of theregistrant’s common stock outstanding, par value $0.00125.

 

 

----

 

**TABLE OF CONTENTS**

 
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                                           |       |
|--------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **   | ** **                                                                                                                          | ** ** |
| Item 1.      | Condensed Consolidated Financial Statements                                                                                         |       |
|         |                                                                                                                                |       |
|         | Condensed Consolidated Balance Sheets as of  June 30, 2004 and December 31, 2003 (unaudited)                              |       |
|         |                                                                                                                                |       |
|         | Condensed Consolidated Statements of  Operations for the three and six month periods ended June 30, 2004 and  2003 (unaudited) |       |
|         |                                                                                                                                |       |
|         | Condensed Consolidated Statements of Cash  Flows for the six month periods ended June 30, 2004 and 2003 (unaudited)            |       |
|         |                                                                                                                                |       |
|         | Notes to Condensed Consolidated Financial  Statements (unaudited)                                                                   |       |
|         |                                                                                                                                |       |
| Item 2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                         |       |
|         |                                                                                                                                |       |
| Item 3.      | Quantitative  and Qualitative Disclosures about Market Risk                                                                         |       |
|         |                                                                                                                                |       |
| Item 4.      | Controls  and Procedures                                                                                                            |       |
|         |                                                                                                                                |       |
| **PART II.** | **OTHER INFORMATION**                                                                                                               |       |
| ** **   | ** **                                                                                                                          | ** ** |
| Item 1.      | Legal  Proceedings                                                                                                                  |       |
|         |                                                                                                                                |       |
| Item 2.      | Changes in Securities, Use of Proceeds and  Issuer Purchases of Equity Securities                                                   |       |
|         |                                                                                                                                |       |
| Item 3.      | Defaults Upon Senior Securities                                                                                                     |       |
|         |                                                                                                                                |       |
| Item 4.      | Submission of Matters to a Vote of Security  Holders                                                                                |       |
|         |                                                                                                                                |       |
| Item 5.      | Other  Information                                                                                                                  |       |
|         |                                                                                                                                |       |
| Item 6.      | Exhibits  and Reports on Form 8-K                                                                                              |       |
|         |                                                                                                                                |       |
|         | Signatures                                                                                                                          |       |
|         |                                                                                                                                |       |
|         | Exhibit  Index                                                                                                                      |       |

 

2

----

 

**PART I—FINANCIAL INFORMATION**

 

**ITEM1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**UTSTARCOM,INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS****(UNAUDITED)**

**(In thousands, except share and per sharedata)**

 
| ** **                                                                                                                                                                             | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                             |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                        |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                              |       | $                       | 484,767    |                        | $          | 373,974 |   |
| Short-term investments                                                                                                                                                                 |       | 76,979                  |       | 48,617                      |       |
| Accounts receivable, net of allowances for  doubtful accounts of $40,317 and $31,172 at June 30, 2004 and  December 31, 2003, respectively                                   |       | 509,608                 |       | 324,921                     |       |
| Accounts receivable, related parties                                                                                                                                                   |       | 29,884                  |       | 43,944                      |       |
| Notes receivable                                                                                                                                                                       |       | 43,392                  |       | 11,362                      |       |
| Inventories                                                                                                                                                                            |       | 435,552                 |       | 257,038                     |       |
| Deferred costs/Inventories at customer  sites under contracts                                                                                                                          |       | 335,640                 |       | 558,977                     |       |
| Prepaids                                                                                                                                                                               |       | 117,995                 |       | 136,262                     |       |
| Restricted cash and short-term investments                                                                                                                                             |       | 42,633                  |       | 24,404                      |       |
| Other current assets                                                                                                                                                                   |       | 39,147                  |       | 52,408                      |       |
| Total current assets                                                                                                                                                                   |       | 2,115,597               |       | 1,831,907                   |       |
| Property, plant and equipment, net                                                                                                                                                     |       | 226,009                 |       | 186,076                     |       |
| Long-term investments                                                                                                                                                                  |       | 24,504                  |       | 24,066                      |       |
| Goodwill                                                                                                                                                                               |       | 113,429                 |       | 100,180                     |       |
| Intangible assets, net                                                                                                                                                                 |       | 64,191                  |       | 44,052                      |       |
| Other long-term assets                                                                                                                                                                 |       | 47,735                  |       | 40,677                      |       |
| Total assets                                                                                                                                                                           |       | $                       | 2,591,465  |                        | $          | 2,226,958 |   |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                          |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                   |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                       |       | $                       | 389,094    |                        | $          | 251,176 |   |
| Income taxes payable                                                                                                                                                                   |       | 28,106                  |       | 16,780                      |       |
| Customer advances                                                                                                                                                                      |       | 149,243                 |       | 458,654                     |       |
| Deferred revenue                                                                                                                                                                       |       | 49,493                  |       | 44,958                      |       |
| Other current liabilities                                                                                                                                                              |       | 205,137                 |       | 173,139                     |       |
| Total current liabilities                                                                                                                                                              |       | 821,073                 |       | 944,707                     |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| Convertible subordinated notes                                                                                                                                                         |       | 402,500                 |       | 402,500                     |       |
| Total liabilities                                                                                                                                                                      |       | 1,223,573               |       | 1,347,207                   |       |
|                                                                                                                                                                                   |       |                    |       |                        |       |
| Commitments and contingencies (Note 16)                                                                                                                                                |       |                    |       |                        |       |
| Minority interest in consolidated  subsidiaries                                                                                                                                        |       | 647                     |       | 560                         |       |
| Stockholders’ equity:                                                                                                                                                             |       |                    |       |                        |       |
| Common stock: $0.00125 par value;  authorized: 750,000,000 shares; issued and outstanding: 113,912,641 and  104,272,477 at June 30, 2004 and December 31, 2003, respectively |       | 143                     |       | 131                         |       |
| Additional paid-in capital                                                                                                                                                             |       | 1,114,632               |       | 653,624                     |       |
| Deferred stock compensation                                                                                                                                                            |       | (7,315                  | )          | (7,761                      | )          |
| Retained earnings                                                                                                                                                                      |       | 255,385                 |       | 229,777                     |       |
| Accumulated other comprehensive income                                                                                                                                                 |       | 4,400                   |       | 3,420                       |       |
| Total stockholders’ equity                                                                                                                                                        |       | 1,367,245               |       | 879,191                     |       |
| Total liabilities, minority interest and  stockholders’ equity                                                                                                                    |       | $                       | 2,591,465  |                        | $          | 2,226,958 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

3

----

 

**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS****(UNAUDITED)**

**(In thousands, except per share data)**

 
| ** **                                                         | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Net sales                                                          |       |                                 |       |                               |       |   |   |   |   |
| Unrelated parties                                                  |       | $                                    | 668,552    |                               | $          | 345,684 |   | $ | 1,279,282 |   | $ | 617,687 |   |
| Related parties                                                    |       | 21,076                               |       | 60,150                             |       | 32,637 |   | 118,667 |   |
|                                                               |       | 689,628                              |       | 405,834                            |       | 1,311,919 |   | 736,354 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Cost of sales                                                      |       | 513,358                              |       | 268,330                            |       | 959,614 |   | 486,165 |   |
| Gross profit                                                       |       | 176,270                              |       | 137,504                            |       | 352,305 |   | 250,189 |   |
| Operating expenses:                                                |       |                                 |       |                               |       |   |   |   |   |
| Selling, general and administrative                                |       | 67,830                               |       | 34,963                             |       | 134,773 |   | 72,546 |   |
| Research and development                                           |       | 52,592                               |       | 36,078                             |       | 98,250 |   | 62,890 |   |
| In-process research and development                                |       | 1,400                                |       | 9,328                              |       | 1,400 |   | 10,648 |   |
| Amortization of intangible assets                                  |       | 3,334                                |       | 1,483                              |       | 6,307 |   | 2,178 |   |
| Total operating expenses                                           |       | 125,156                              |       | 81,852                             |       | 240,730 |   | 148,262 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Operating income                                                   |       | 51,114                               |       | 55,652                             |       | 111,575 |   | 101,927 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Interest income                                                    |       | 1,838                                |       | 699                                |       | 3,191 |   | 1,642 |   |
| Interest expense                                                   |       | (1,139                               | )          | (2,210                             | )          | (2,221 | ) | (2,849 | ) |
| Other income, net                                                  |       | 4,263                                |       | 154                                |       | 13,048 |   | 4,340 |   |
| Equity in loss of affiliated companies                             |       | (1,201                               | )          | (1,745                             | )          | (2,198 | ) | (2,720 | ) |
| Income before income taxes and minority  interest                  |       | 54,875                               |       | 52,550                             |       | 123,395 |   | 102,340 |   |
| Income tax expense                                                 |       | 10,975                               |       | 13,138                             |       | 24,679 |   | 25,585 |   |
| Minority interest in earnings (loss) of  consolidated subsidiaries |       | (37                                  | )          | —                             |       | (87 | ) | — |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Net income                                                         |       | $                                    | 43,863     |                               | $          | 39,412 |   | $ | 98,629 |   | $ | 76,755 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Basic earnings per share                                           |       | $                                    | 0.39       |                               | $          | 0.39 |   | $ | 0.86 |   | $ | 0.74 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Diluted earnings per share                                         |       | $                                    | 0.33       |                               | $          | 0.33 |   | $ | 0.73 |   | $ | 0.65 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| Weighted average shares used in per-share  calculation:            |       |                                 |       |                               |       |   |   |   |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| - Basic                                                            |       | 113,773                              |       | 100,698                            |       | 114,193 |   | 104,009 |   |
|                                                               |       |                                 |       |                               |       |   |   |   |   |
| - Diluted                                                          |       | 136,095                              |       | 124,360                            |       | 137,709 |   | 119,641 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

----

 

**UTSTARCOM,INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS****(UNAUDITED)**

**(In thousands)**

 
| ** **                                                                     | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                          |       |                               |       |   |   |
| Net income                                                                     |       | $                                  | 98,629     |   | $ | 76,755 |   |
| Adjustments to reconcile net income to net  cash used in operating activities: |       |                               |       |   |   |
| Depreciation and amortization                                                  |       | 33,988                             |       | 17,729 |   |
| Non-qualified stock option exercise tax  benefits                              |       | 3,541                              |       | 8,231 |   |
| Net loss on sale of assets                                                     |       | 66                                 |       | 690 |   |
| In-process research and development costs                                      |       | 1,400                              |       | 10,648 |   |
| Amortization of debt issuance costs                                            |       | 1,166                              |       | 777 |   |
| Warrants adjustment to fair value                                              |       | 32                                 |       | (158 | ) |
| Loss on sale of investment                                                     |       | —                             |       | 73 |   |
| Net   loss on long-term investments                                       |       | 469                                |       | — |   |
| Stock compensation expense                                                     |       | 245                                |       | 3,074 |   |
| Provision for doubtful accounts                                                |       | 9,485                              |       | 1,123 |   |
| Inventory provision                                                            |       | 15,853                             |       | (8,105 | ) |
| Equity in loss of affiliated companies                                         |       | 2,198                              |       | 2,720 |   |
| Deferred income taxes                                                          |       | (4,546                             | )          | (1,686 | ) |
| Minority interest in earnings of  consolidated subsidiary                      |       | 87                                 |       | — |   |
| Changes in operating assets and  liabilities:                                  |       |                               |       |   |   |
| Accounts receivable                                                            |       | (179,074                           | )          | (42,259 | ) |
| Inventories                                                                    |       | (192,985                           | )          | (254,076 | ) |
| Deferred costs/Inventories at customer  sites under contracts                  |       | 223,337                            |       | (405,853 | ) |
| Other current and non-current assets                                           |       | 2,112                              |       | (121,038 | ) |
| Accounts payable                                                               |       | 136,856                            |       | 165,590 |   |
| Income taxes payable                                                           |       | 11,326                             |       | (8,122 | ) |
| Customer advances                                                              |       | (309,772                           | )          | 9,188 |   |
| Deferred revenue                                                               |       | 4,493                              |       | 362,240 |   |
| Other current liabilities                                                      |       | 22,549                             |       | 26,525 |   |
| Net cash used in operating activities                                          |       | (118,545                           | )          | (155,934 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                          |       |                               |       |   |   |
| Additions to property, plant and equipment                                     |       | (62,466                            | )          | (41,192 | ) |
| Investment in affiliates, net of cash  acquired                                |       | (1,000                             | )          | (1,000 | ) |
| Purchase of businesses, net of cash  acquired                                  |       | (44,711                            | )          | (109,520 | ) |
| Proceeds from disposal of property                                             |       | —                             |       | 21 |   |
| Purchase of intellectual property licenses                                     |       | (3,540                             | )          | — |   |
| Change in restricted cash                                                      |       | (8,677                             | )          | (4,032 | ) |
| Purchase of short-term investments                                             |       | (132,654                           | )          | (37,307 | ) |
| Proceeds from sale of short-term  investments                                  |       | 97,369                             |       | 150,278 |   |
| Net cash used in investing activities                                          |       | (155,679                           | )          | (42,752 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                          |       |                               |       |   |   |
| Issuance of stock, net of expenses                                             |       | 17,672                             |       | 34,959 |   |
| Purchase of bond hedge and call option                                         |       | —                             |       | (43,792 | ) |
| Net proceeds from borrowing                                                    |       | —                             |       | 391,431 |   |
| Repurchase of stock                                                            |       | (107,567                           | )          | (139,609 | ) |
| Proceeds from stockholder notes                                                |       | —                             |       | 7 |   |
| Proceeds from equity offering                                                  |       | 474,554                            |       | — |   |
| NET CASH PROVIDED BY FINANCING ACTIVITIES                                      |       | 384,659                            |       | 242,996 |   |
| Effect of exchange rate changes on cash                                        |       | 358                                |       | (276 | ) |
| Net increase in cash and cash equivalents                                      |       | 110,793                            |       | 44,034 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                              |       | 373,974                            |       | 231,944 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                     |       | $                                  | 484,767    |   | $ | 275,978 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

----

 

**UTSTARCOM, INC.**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

 

**1.****                                      BASISOF PRESENTATION:**

 

The accompanying unaudited condensed consolidated financial statementsinclude the accounts of UTStarcom, Inc. (the “Company”) and its wholly andmajority owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated in the preparation of the condensedconsolidated financial statements. The minority interests in consolidatedsubsidiaries and equity in affiliated companies are shown separately in thecondensed consolidated financial statements. Investments in affiliatedcompanies are accounted for using the cost or equity method, as applicable.

 

The accompanying financial statements as of June 30, 2004 and forthe three and six months ended June 30, 2004 and 2003 have been preparedby the Company, without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission (“SEC”). Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The December 31, 2003 balancesheet was derived from audited financial statements, but does not include alldisclosures required by generally accepted accounting principles. Thesecondensed consolidated financial statements should be read in conjunction withthe Company’s audited December 31, 2003 financial statements, includingthe notes thereto, and the other information set forth in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2003. Certainreclassifications have been made to prior period balances in order to conformto the current year presentation.

 

In the opinion of management, the accompanying condensed consolidatedfinancial statements reflect all adjustments (consisting of only normalrecurring adjustments) considered necessary for a fair presentation of theCompany’s financial condition, the results of its operations and its cash flowsfor the periods indicated. The results of operations for the three and sixmonths ended June 30, 2004 are not necessarily indicative of the operatingresults for the full year.

 

**2.****                                      REVENUERECOGNITION:**

 

Revenues from sales of telecommunications equipment are recognized whenpersuasive evidence of an arrangement exists, delivery of the product hasoccurred, customer acceptance has been obtained, the fee is fixed ordeterminable and collectability is reasonably assured. If the payment due fromthe customer is not fixed or determinable due to extended payment terms,revenue is recognized as payments become due from the customer, assuming allother criteria for revenue recognition are met. Any payments received prior torevenue recognition are recorded as customer advances. Normal payment termsdiffer for various reasons amongst different customer regions, depending uponcommon business practices for customers within a region. Shipping and handlingcosts are recorded as revenues and costs of revenues. Any expected losses on contractsare recognized immediately.

 

Sales may be generated from complex contractual arrangements thatrequire significant revenue recognition judgments, particularly in the areas ofmultiple element arrangements. Where multiple elements exist in an arrangement,the arrangement fee is allocated to the different elements based uponverifiable objective evidence of the fair value of the elements, as governedunder EITF 00-21, and SEC Staff Accounting Bulletin No. 104 “SAB 104.”Multiple element arrangements primarily involve the sale of Personnel AccessSystems (“PAS”), a family of wireless access handsets, wireless consumerproducts and core infrastructure equipment or Internet Protocol-based PAS(“iPAS”) wireless access systems that employ micro cell radio technology andspecialized handsets, allowing service providers to offer subscribers bothmobile and fixed access to telephone services. These multiple elementarrangements include the sale of PAS or iPAS equipment with handsets,installation and training and the provision of such equipment to differentlocations for the same customer. Revenue is recognized as each element isearned, namely upon installation and acceptance of equipment or delivery ofhandsets, provided that the fair value of the undelivered element(s) has beendetermined, the delivered element has stand-alone value, there is no right ofreturn on delivered element(s), and the vendor is in control of the undeliveredelement(s).

 

Final acceptance is required for revenue recognition when installationservices are not considered perfunctory. Final acceptance indicates that thecustomer has fully accepted delivery of equipment and the Company is entitledto the full payment. The Company will not recognize revenue before finalacceptance is granted by the customer if acceptance is considered substantiveto the transaction. Additionally, the Company does not recognize revenue whencash payments are received from customers for transactions that do not have thecustomer’s final acceptance. The Company records these cash receipts ascustomer ad vances, and defers revenue recognition until final acceptance isreceived.

 

Where multiple elements exist in an arrangement that includes softwareand the software is considered more than incidental to the equipment orservices in the arrangement, software and software-related elements arerecognized under the

 

6

----

 

provisions of Statement of Position 97-2, as amended, and EmergingIssues Task Force Issue No. 03-05. The Company allocates revenues to eachelement of software arrangements based on vendor-specific objective evidence(“VSOE”). VSOE of each element is based on the price charged when the sameelement is sold separately. The Company uses the residual method to recognizerevenue when an arrangement includes one or more elements to be delivered at afuture date and VSOE of the fair value of all the undelivered elements exists.Under the residual method, the fair value of the undelivered elements isdeferred and the remaining portion of the arrangement fee is recognized asrevenue. If evidence of fair value of one or more undelivered elements does notexist, revenue is deferred and recognized when delivery of those elementsoccurs or when fair value can be established.

 

The Company recognizes revenue for system integration, installation andtraining upon completion of performance if all other revenue recognitioncriteria are met. Other service revenue, such as that related to maintenanceand support contracts, is recognized ratably over the contract term. Revenuesfrom services were less than 10% of revenues for all periods.

 

The Company also sells products through resellers. Revenue is generallyrecognized when the standard price protection period, which ranges from 30 to90 days, has lapsed. If collectability cannot be reasonably assured in areseller arrangement, revenue is recognized upon sell-through to the endcustomer and receipt of cash. There may be additional obligations in resellerarrangements such as inventory rotation, or stock exchange rights on theproduct. As such, revenue is recognized in accordance with Statement ofFinancial Accounting Standards No. 48 “Revenue Recognition When Right ofReturn Exists” (“SFAS 48”). The Company has developed reasonable estimates forstock exchanges. Estimates are derived from historical experience with similartypes of sales of similar products.

 

The assessment of collectability is also a factor in determiningwhether revenue should be recognized. The Company assesses collectability basedon a number of factors, including payment history and the credit-worthiness ofthe customer. The Company does not request collateral from its customers. Ininternational sales, the Company often requires letters of credit from its customersthat can be drawn on demand if the customer defaults on its payment. If theCompany determines that collection of a payment is not reasonably assured, theCompany recognizes revenue at the time collection becomes reasonably assured,which is generally upon receipt of cash.

 

Because of the nature of doing business in China and other emergingmarkets, the Company’s billings and/or customer payments may not correlate withthe contractual payment terms and the Company generally does not enforcecontractual payment terms prior to final acceptance. Accordingly, accountsreceivable are not booked until the Company recognizes the related customerrevenue.  Advances from customers arerecognized when the Company has collected cash from the customer, prior to recognizingrevenue. Deferred revenue is recorded if there are undelivered elements afterfinal acceptance has been obtained.

 

The Company provides a warranty on its equipment and handset sales fora period generally ranging from one to three years from the time of finalacceptance. The Company provides for the expected cost of product warranties atthe time that revenue is recognized, based on an assessment of past warrantyexperience.

 

**3.****                                      EARNINGSPER SHARE:**

 

Basic earnings per share is computed by dividing net income availableto holders of common stock by the weighted average number of shares of theCompany’s common stock outstanding during the period. Diluted earnings pershare is determined by adjusting net income as reported by the effect ofdilutive securities and increasing the number of shares by potentially dilutiveshares of common stock outstanding during the period. Potentially dilutiveshares of common stock consist of employee stock options, a written calloption, warrants, convertible subordinated notes and unvestedacquisition-related stock options.

 

The following is a summary of the calculation of basic and dilutedearnings per share (in thousands, except per share data):

 

7

----

 
| ** **                                    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator:                                    |       |                                 |       |                               |       |   |   |   |   |
|                                          |       |                                 |       |                               |       |   |   |   |   |
| Net income (for basic EPS computation)        |       | $                                    | 43,863     |                               | $          | 39,412 |   | $ | 98,629 |   | $ | 76,755 |   |
|                                          |       |                                 |       |                               |       |   |   |   |   |
| Effect of Dilutive Securities                 |       |                                 |       |                               |       |   |   |   |   |
| 7/8% Convertible Subordinated Notes           |       | 884                                  |       | 1,092                              |       | 1,798 |   | 1,375 |   |
|                                          |       |                                 |       |                               |       |   |   |   |   |
| Net income adjusted for dilutive securities   |       | $                                    | 44,747     |                               | $          | 40,504 |   | $ | 100,427 |   | $ | 78,130 |   |
|                                          |       |                                 |       |                               |       |   |   |   |   |
| Denominator:                                  |       |                                 |       |                               |       |   |   |   |   |
|                                          |       |                                 |       |                               |       |   |   |   |   |
| Shares used to compute basic EPS              |       | 113,773                              |       | 100,698                            |       | 114,193 |   | 104,009 |   |
| Dilutive common stock equivalent shares:      |       |                                 |       |                               |       |   |   |   |   |
| Stock options                                 |       | 5,010                                |       | 6,086                              |       | 5,668 |   | 4,823 |   |
| Written call option                           |       | —                               |       | —                             |       | 523 |   | — |   |
| Conversion of convertible subordinated  notes |       | 16,919                               |       | 16,919                             |       | 16,919 |   | 10,151 |   |
| Warrants                                      |       | 5                                    |       | 29                                 |       | 17 |   | 29 |   |
| Unvested acquisition-related stock            |       | 388                                  |       | 628                                |       | 389 |   | 629 |   |
| Shares used to compute diluted EPS            |       | 136,095                              |       | 124,360                            |       | 137,709 |   | 119,641 |   |
| Basic earnings per share                      |       | $                                    | 0.39       |                               | $          | 0.39 |   | $ | 0.86 |   | $ | 0.74 |   |
| Diluted earnings per share                    |       | $                                    | 0.33       |                               | $          | 0.33 |   | $ | 0.73 |   | $ | 0.65 |   |

 

8

----

 

Certain potential shares related to employee stock options and warrantsoutstanding during the three and six months ended June 30, 2004 and 2003were excluded in the diluted per share computations, since their exerciseprices were greater than the average market price of the Company’s common stockduring the period and, accordingly, their effect is anti-dilutive. For thethree months ended June 30, 2004 and 2003, these shares totaled2.0 million with a weighted average exercise price of $36.56 per share and1.9 million shares with a weighted average exercise price of $28.67 pershare, respectively. For the six months ended June 30, 2004 and 2003,these shares totaled 1.8 million with a weighted average exercise price of$37.49 per share and 3.2 million shares with a weighted average exerciseprice of $26.89 per share, respectively. 

 

On June 30, 2004, each of the Company’s7/8% convertible subordinated notes outstanding was eligible forconversion into shares of common stock. For each $1,000 of aggregate principalamount of notes converted, the Company will deliver approximately 42.0345shares of common stock, if the Company’s stock price exceeds a specifiedthreshold of $26.10. At June 30, 2004, the closing price of the Company’scommon stock exceeded the specified threshold, which had the effect ofincreasing the denominator for diluted earnings per share by 16.9 million.  In the June 30, 2003 10-Q, the earnings pershare calculation for the six months ended June 30, 2003 was calculated as ifthe convertible bond had been outstanding for the entire six months rather thanfor the period from issuance on March 12, 2003 through June 30, 2003.  This calculation was corrected in theSeptember 30, 2003 10-Q filing.  As aresult, in this filing, the calculation of the weighted average number ofdilutive shares attributable to the convertible bond for the six months ended June30, 2003 decreased from 16.9 million to 10.2 million shares resulting in anincrease in the June 30, 2003 dilutive earnings per share of three cents from$0.62 per share to $0.65 per share.  TheCompany entered into convertible bond hedge and call option transactions toreduce the potential dilution from conversion of the notes. Both the bond hedgeand call option transactions may be settled at the Company’s option either incash or net shares and expire on March 1, 2008.

 

Additionally, during the three months endedJune 30, 2004, the average price of the Company’s stock exceeded thespecified strike price of the convertible bond hedge that the Company enteredinto to reduce the potential dilution from conversion of the notes. Using thetreasury stock method, under Statement of Financial Accounting StandardsNo. 128, “Earnings Per Share” (“SFAS 128”), this would have theeffect of decreasing the denominator for diluted earnings per share by2.9 million for the three months ended June 30, 2004. This would havethe effect of decreasing the denominator for diluted earnings per share by 1.6million for the three months ended June 30, 2003.

 

For the six months ended June 30, 2004, the dilutive andanti-dilutive effects of the call option and the bond hedge were derived bytaking the weighted average effects of the first and second quarters, inaccordance with SFAS 128. For the six months ended June 30, 2004, thiswould have the effect of decreasing the denominator for diluted earnings pershare by 4.0 million shares for the bond hedge transaction, and increasingthe denominator for diluted earnings per share by 0.5 million shares forthe call option transaction. For the six months ended June 30, 2003, this wouldhave the effect of decreasing the denominator for diluted earnings per share by0.8 million shares for the bond hedge transaction. However, only the dilutiveeffect of the 0.5 million shares with respect to the call optiontransaction was included in the Company’s diluted earnings per sharecalculation above. The convertible bond hedge, under SFAS 128, is alwaysanti-dilutive.

 

The net income for the diluted EPS computation reflects the reductionin interest expense of $0.9 million and $1.8 million for the three and sixmonths ended June 30, 2004, respectively, that would result from anassumed conversion of the 7/8% convertible subordinated notes.The net income for the diluted EPS computation reflects the reduction ininterest expense of $1.1 million and $1.4 million for the three and six monthsended June 30, 2003, respectively, that would result from an assumedconversion of the 7/8% convertible subordinated notes.

 

**4.****                                      STOCK-BASEDCOMPENSATION:**

 

The Company accounts for employee stock option grants in accordancewith Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”) and has adopted the disclosure-only alternativeof SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS 123”). Under APB 25, compensation expense isbased on the difference, if any, on the date of grant between the fair value ofthe common stock and the exercise price of the option.

 

The fair value of warrants, options or stock exchanged for servicesfrom non-employees is expensed over the period benefited. The warrants andoptions are valued using the Black-Scholes option-pricing model.

 

9

----

 

The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS No. 123 to stock-based employee compensation (in thousands, exceptper share data):

 
| ** **                                                                                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Basic                                                                                                                    |       |                                 |       |                               |       |   |   |   |   |
| Net income:                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | 43,863     |                               | $          | 39,412 |   | $ | 98,629 |   | $ | 76,755 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Add:   Stock-based employee compensation expense included  in reported net income, net of related tax  effects |       | 120                                  |       | 1,681                              |       | 175 |   | 2,181 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Deduct: Total compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | (9,092                               | )          | (7,786                             | )          | (17,057 | ) | (14,202 | ) |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Pro forma net income                                                                                                     |       | $                                    | 34,891     |                               | $          | 33,307 |   | $ | 81,747 |   | $ | 64,734 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Basic income per share:                                                                                                  |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | 0.39       |                               | $          | 0.39 |   | $ | 0.86 |   | $ | 0.74 |   |
| Pro forma                                                                                                                |       | $                                    | 0.31       |                               | $          | 0.33 |   | $ | 0.72 |   | $ | 0.62 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Diluted                                                                                                                  |       |                                 |       |                               |       |   |   |   |   |
| Net income:                                                                                                              |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | 43,863     |                               | $          | 39,412 |   | $ | 98,629 |   | $ | 76,755 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Effect of dilutive securities                                                                                            |       |                                 |       |                               |       |   |   |   |   |
| 7/8% Convertible subordinated notes                                                                                      |       | 884                                  |       | 1,092                              |       | 1,798 |   | 1,375 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Add:   Stock-based employee compensation expense included  in reported net income, net of related tax  effects |       | 120                                  |       | 1,681                              |       | 175 |   | 2,181 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Deduct: Total compensation expense determined  under fair value based method for all awards, net of related tax effects  |       | (9,092                               | )          | (7,786                             | )          | (17,057 | ) | (14,202 | ) |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Pro forma net income                                                                                                     |       | $                                    | 35,775     |                               | $          | 34,399 |   | $ | 83,545 |   | $ | 66,109 |   |
|                                                                                                                     |       |                                 |       |                               |       |   |   |   |   |
| Diluted income per share:                                                                                                |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                              |       | $                                    | 0.33       |                               | $          | 0.33 |   | $ | 0.73 |   | $ | 0.65 |   |
| Pro forma                                                                                                                |       | $                                    | 0.27       |                               | $          | 0.29 |   | $ | 0.62 |   | $ | 0.57 |   |

 

**5.****                                      COMPREHENSIVEINCOME:**

 

The reconciliation of net income to comprehensive income for the threeand six months ended June 30, 2004 and 2003 is as follows (in thousands):

 

10

----

 
| ** **                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income                                    |       | $                                    | 43,863     |                               | $          | 39,412 |   | $ | 98,629 |   | $ | 76,755 |   |
| Unrealized gains (losses) on investments      |       | 712                                  |       | 609                                |       | 479 |   | 1,183 |   |
| Change in cumulative translation  adjustments |       | (173                                 | )          | (10                                | )          | 501 |   | (44 | ) |
| Total comprehensive income                    |       | $                                    | 44,402     |                               | $          | 40,011 |   | $ | 99,609 |   | $ | 77,894 |   |

 

**6.****                                      CASH,CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:**

 

Cash and cash equivalents consist of instruments with maturities ofthree months or less at the date of purchase. There were no available-for-salesecurities included in cash and cash equivalents at June 30, 2004 orDecember 31, 2003. Short-term investments, consisting entirely of available-for-salesecurities, were $77.0 million and $48.6 million at June 30, 2004 andDecember 31, 2003, respectively. These available-for-sale securitiesconsist of government-backed notes, commercial paper, floating rate corporatebonds and fixed income corporate bonds. These investments are recorded at fairvalue. Any unrealized holding gains or losses are reported as a component ofcomprehensive income. Realized gains and losses are reported in earnings.

 

The Company accepts bank notes receivable with maturity dates betweenthree and six months from its customers in China in the normal course ofbusiness. Bank notes receivable were $100.0 million and $11.5 million atJune 30, 2004 and December 31, 2003, respectively, and have beenincluded in cash and cash equivalents and short-term investments. The Companymay discount these notes with banking institutions in China. A sale of thesenotes is reflected as a reduction of cash and cash equivalents or short-terminvestments and the proceeds of the settlement of these notes are included incash flows from operating activities in the consolidated statement of cashflows. There were no bank notes receivable sold during the three and six monthsended June 30, 2004; there were $82.3 million and $111.3 million of banknotes receivable sold during the three and six months ended June 30, 2003,respectively.  Any notes that have beensold are not included in the Company’s consolidated balance sheets as thecriteria for sale treatment established by Statement of Financial AccountingStandards No. 140, “Accounting for Transfers and Servicing of FinancialAssets and Extinguishment of Liabilities” (“SFAS 140”), has been met.Under SFAS 140, upon a transfer, the transferor or entity must derecognizefinancial assets when control has been surrendered and the transferee obtainscontrol over the assets. In addition, the transferred assets have been isolatedfrom the transferor, beyond the reach of its creditors, and the transferee hasthe right, without conditions or constraints, to pledge or exchange the assetsit has received. The costs of settling or transferring these notes receivablewere $0.4 million for both the three and six months ended June 30, 2003. 

 

**7.****                                      RESTRICTEDCASH AND SHORT-TERM INVESTMENTS:**

 

At June 30, 2004, the Company had restricted cash and short-terminvestments of $42.6 million primarily comprised of $27.4 million of restrictedshort-term investments and $8.5 million of restricted cash for standby lettersof credit, $2.9 million of restricted cash held in escrow as it relates to theCompany’s acquisition of TELOS and restricted cash of a $3.7 million timedeposit required for Japanese tax purposes.  At December 31, 2003,the Company had restricted cash and short-term investments of $24.4 millionprimarily comprised of $20.5 million of restricted short-term investments forstandby letters of credit and restricted cash of a $3.7 million time depositrequired for Japanese tax purposes.

 

The Company issues standby letters of credit primarily to supportinternational sales activities outside of China. When the Company submits a bidfor a sale, often the potential customer will require that the Company issue abid bond or a standby letter of credit to demonstrate its commitment throughthe bid process.  In addition, the Company may be required to issuestandby letters of credit as guarantees for advance customer payments uponcontract signing or performance guarantees. The standby letters of creditusually expire six to nine months from date of issuance without being drawn bythe beneficiary thereof. Finally, the Company may issue commercial letters ofcredit in support of purchase commitments.

 

**8.****                                      ACCOUNTSAND NOTES RECEIVABLE:**

 

The Company accepts commercial notes receivable with maturity datesbetween three and six months from its customers in China in the normal courseof business. Notes receivable available for sale were $42.9 million and$11.4 million at June 30, 2004 and December 31, 2003,respectively. The Company may discount these notes with banking institutions inChina. A sale of these notes is reflected as a reduction of notes receivableand the proceeds of the settlement of these notes are included in cash flowsfrom operating activities in the consolidated statement of cash flows. Therewere no notes receivable sold during the three and six months endedJune 30, 2004; there were $25.3 million and $44.5 million of notesreceivable sold during the three and six months ended June 30, 2003,respectively.  Any notes that have beensold are not included in the Company’s consolidated balance sheets as thecriteria for sale treatment established by SFAS 140, has been met. The costs ofsettling or transferring these notes receivable were $0.3 million and $0.5million for the three and six months ended June 30,

 

11

----

 

2003, respectively, and were included in other income, net in theConsolidated Statements of Operations. 

 

**9.****                                      SUPPLEMENTALDISCLOSURES OF CASH FLOW INFORMATION:**

 
| ** **                       | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|------------------------------------|------------|
| **(in  thousands)**              | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                             |       |                               |       |   |   |
| Cash paid during the period for: |       |                               |       |   |   |
| Interest                         |       | $                                  | 1,773      |   | $ | 508 |   |
| Income taxes                     |       | $                                  | 3,818      |   | $ | 21,606 |   |

 
| ** **                                           | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------|------------|
| **(in  thousands)**                                  | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| Non-cash operating activities were as  follows:      |       |                               |       |   |   |
| Accounts receivable transferred to notes  receivable |       | $                                  | 55,876     |   | $ | 25,258 |   |
|                                                      |            |                                    |            |  |  |  |  |

 

**10.****                               INVENTORIESAND DEFERRED COSTS/INVENTORIES AT CUSTOMER SITES UNDER CONTRACTS:**

 

As of June 30, 2004 and December 31, 2003, total inventoriesand deferred costs/inventories at customer sites under contracts consist of thefollowing:

 
| ** **                                                      | ** ** | **June 30,**  | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2004**           | ** ** | **2003**              | ** ** |
| ** **                                                      | ** ** | **(in thousands)** | ** ** |
| *Inventories*                                                   |       |               |       |                  |       |
| Raw materials                                                   |       | $                  | 164,601    |                  | $          | 66,753 |   |
| Work-in-process                                                 |       | 84,461             |       | 51,116                |       |
| Finished goods                                                  |       | 63,827             |       | 48,206                |       |
| Inventories at customer sites without  contracts                |       | 122,663            |       | 90,963                |       |
|                                                            |       | $                  | 435,552    |                  | $          | 257,038 |   |
|                                                            |       |               |       |                  |       |
| *Deferred  costs/Inventories at customer sites under contracts* |       | $                  | 335,640    |                  | $          | 558,977 |   |

 

**11.****                               ACQUISITIONS**

 

# *TELOSTechnology, Inc.*

 

On May 19, 2004,the Company completed its acquisition of substantially all of the assets andcertain liabilities of TELOS Technology, Inc. (“TELOS”) and itssubsidiaries.  TELOS is a provider ofmobile switching products and services for voice and data communicationnetworks to developing rural, enterprise and emerging wireless markets. Thetotal consideration for the acquisition, funded from cash on hand, wasapproximately $30.3 million.  The Companypaid $29.0 million in cash, in addition to $1.3 million of acquisition-relatedtransaction costs. Within one year of the acquisition date, additional paymentstotaling a maximum of $19.0 million may become payable based upon revenuerecognized from the sale of TELOS products. In the event these revenuemilestones are met, the original purchase price will be adjusted for the amountof the contingent payment in accordance with Statement of Financial AccountingStandards No. 141 (“SFAS 141”), “Business Combinations.”

 

The existingtechnology acquired included the entire TELOS product family of code divisionmultiple access (or “CDMA”) softswitch technology products, supporting serversand operations maintenance centers. CDMA technology is the common platform onwhich third-generation wireless data services and applications are built. Byassigning unique codes to each communication to differentiate it from others inthe same spectrum, CDMA technology allows many users to occupy the same timeand frequency allocations in a given band or space. The TELOS product line willbe integrated with the Company’s suite of CDMA products, strengthening theCompany’s existing CDMA product portfolio. In addition to developed producttechnology, the Company acquired fixed assets, in-process research anddevelopment (“IPR&D”), an

 

12

----

 

assembledworkforce of approximately 60 employees, customer relationships and recordedgoodwill.

 

Subsequent tothe May 19, 2004 acquisition of TELOS, the Company completed the allocation ofthe purchase price based in part upon an independent valuation. The amount ofthe purchase price allocated to IPR&D of $1.4 million was charged to theCompany’s results of operations, as no alternative future uses existed at theacquisition date. The Company recorded goodwill of $6.6 million in connection withthe acquisition. The results of operations of TELOS have been included in theCompany’s consolidated results of operations beginning on the acquisition dateof May 19, 2004.

 

In assessingTELOS’s IPR&D projects, the Company considered key product characteristicsincluding the product’s development stage at the acquisition date, theproduct’s life cycle and the product’s future prospects. The Company alsoconsidered the rate at which technology changes in the telecommunicationsequipment industry, the industry’s competitive environment and the economicoutlook for both local and global markets.

 

As of theacquisition date, TELOS had two projects under development that qualified forIPR&D: the Sonata SE product family and the iCell product. The objective ofboth projects is to enhance the functionality of products designed to complywith the CDMA2000 technology standard. Specifically, the objective of theSonata SE product family is to provide additional features to operationmaintenance center products. The objective of the iCell product is to enhanceiCell base station features.

 

The projectsunder development are enhancements to existing products that do not affect thefunctionality of those existing products. As such, the significant risk theCompany faces is to complete these projects within the scope of the budget. Asof the closing date, the Sonata SE and the iCell projects were approximately20% and 30% complete, respectively.  Asof June 30, 2004, anticipated completion dates and estimated costs tocomplete the Sonata SE and iCell projects were June 2005 and $1.1 millionand December 2004 and $0.2 million, respectively.

 

The following tablesummarizes the allocation of the purchase price for TELOS based upon theindependent valuation: 

 
| ** **                                                                                       | ** ** | **May 19, 2004**   | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                       | ** ** | **(in thousands)** | ** ** |
| Fair value of tangible net assets                                                                |       |               |       |
| Inventory                                                                                        |       | $                  | 1,382      |   |
| Property, plant and equipment                                                                    |       | 2,010              |       |
| Other tangible assets                                                                            |       | 1,369              |       |
| Customer relationships                                                                           |       | 5,000              |       |
| Existing technology                                                                              |       | 15,900             |       |
| In-process research and development                                                              |       | 1,400              |       |
| Liabilities assumed                                                                              |       | (3,380             | )          |
| Excess of costs of acquiring TELOS over  fair value of identified net assets acquired (goodwill) |       | 6,625              |       |
|                                                                                             |       |               |       |
|                                                                                             |       | $                  | 30,306     |   |

 

The estimated useful livesof the customer relationships and existing technology intangible assets arefive years.

 

Refer to the consolidatedtable below for the pro forma results of operations reflecting the combinedresults of the Company and TELOS for the three and six months endedJune 30, 2004 and 2003 as if the business combination occurred at thebeginning of the period.  These results do not purport to be indicative ofwhat would have occurred had the acquisition been made as of that date or theresults of operations which may occur in future periods. 

 

# *HyundaiSyscomm, Inc.*

 

On April 27,2004, the Company completed its acquisition of the assets, substantially all ofthe intellectual property, certain employees and certain contracts related toHyundai Syscomm, Inc.’s (“HSI”) CDMA infrastructure business for marketsoutside of Korea.  Subject to theattainment of certain milestones and the transfer of certain know-how, thetotal

 

13

----

 

consideration for this transaction was approximately $12.3 millionexcluding transaction costs of $1.8 million. There was $7.3 million in cashpayable at the closing date and an additional $3.0 million in cash payable oneyear from the closing date. The remaining purchase price was comprised of $2.0million payable upon the completion of technical training by HSI employees toCompany manufacturing staff in China under the terms of a Training ServicesAgreement and $1.8 million of transaction costs. Not included in the purchaseprice was $2.0 million payable upon the completion of certain revenuemilestones. In the event these revenue milestones are met, the originalpurchase price will be adjusted for the amount of the contingent payment inaccordance with Statement of Financial Accounting Standards No. 141 (“SFAS141”), “Business Combinations.” In conjunction with this transaction, theCompany loaned HSI $3.2 million at an effective interest rate of 12% per annum,which was used by HSI to satisfy outstanding debt obligations. The principalamount of the loan is due in April 2005. The Company may contractuallyoffset HSI’s payment obligations against the outstanding $3.0 million of thepurchase price and any other liabilities.

 

Under theterms of the transaction with HSI, the Company acquired existing technologiesand entered into non-compete and licensing agreements. The existingtechnologies acquired were the base transceiver station (“BTS”) and basestation controllers (“BSC”) product lines. BTS is the antenna and radio equipment that enables wireless devices tocommunicate with a land-based transmission network in a given range. BSCperforms radio signal management functions for BTS, managing functions such asfrequency assignment and handoff. As part of the asset purchase agreement, theCompany and HSI entered into a training services agreement, whereby HSIemployees will provide technical training to Company manufacturing staff inChina for the sixth-month period subsequent to the acquisition. This technologyand technological know-how will strengthen the Company’s existing CDMA productportfolio and the development of future CDMA technology.

 

In addition toacquiring existing technology, the Company entered non-compete and licensingagreements.  The non-compete agreementprohibits HSI from competing against the Company in all countries except Koreafor three years from the valuation date. The licensing agreement requires thatHSI pay the Company 1% of revenue as royalty for the usage of the intellectualproperty that the Company acquired under the terms of the acquisition forfifteen years subsequent to the valuation date.

 

Subsequent tothe April 27, 2004 acquisition of HSI, the Company completed theallocation of the purchase price based in part upon an independent valuation.The Company recorded goodwill of $6.8 million in connection with theacquisition. The results of operations of HSI have been included in theCompany’s consolidated results of operations beginning on the acquisition dateof April 27, 2004.

 

The following tablesummarizes the final allocation of the purchase price for HSI based upon thefinal independent valuation: 

 
| ** **                                                                                     | ** ** | **April 27, 2004** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                     | ** ** | **(in thousands)**      | ** ** |
| Fair value of tangible net assets                                                              |       |                    |       |
| Property, plant and equipment                                                                  |       | $                       | 1,440      |   |
| Other tangible assets                                                                          |       | 673                     |       |
| Existing technology                                                                            |       | 3,559                   |       |
| Non-compete intangible asset                                                                   |       | 760                     |       |
| IP license agreement                                                                           |       | 890                     |       |
| Excess of costs of acquiring HSI over fair  value of identified net assets acquired (goodwill) |       | 6,750                   |       |
|                                                                                           |       |                    |       |
|                                                                                           |       | $                       | 14,072     |   |

 

The intangible assets haveestimated useful lives ranging from three to five years as follows: existingtechnology, five years; non-compete agreement, three years; intellectualproperty license agreement, three years.

 

Refer to the consolidated table below for pro forma resultsof operations reflecting the combined results of the Company and HSI for thethree and six months ended June 30, 2004 and 2003 as if the businesscombination occurred at the beginning of the period.  These results do notpurport to be indicative of what would have occurred had the acquisition beenmade as of that date or the results of operations which may occur in futureperiods. 

 

14

----

 

The pro formaresults of operations include historical operations of the Company, TELOS andHSI. Certain non-recurring charges were recorded by TELOS andincluded $2.3 million of expense for warrants issued in conjunction with anissuance of senior convertible notes in the second quarter of 2003 and $0.1million of restructuring costs incurred in the first quarter of 2003.

 
| *** ***                                         | ** ** | **UT Starcom, Inc.**              | ** ** | **TELOS Technology, Inc.**        | ** ** | **Hyundai Syscomm, Inc.**                    | ** ** | **Pro Forma adjustments to  reflect depreciation and  amortization of acquired assets** | ** ** | **Pro Forma Results**                          | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| **(In  thousands,  except per share**                | ** ** | **Three Months  Ended  June 30,** | ** ** | **Three Months  Ended  June 30,** | ** ** | **For the period  from April 1  to May 19,** | ** ** | **Three Months  Ended  June 30,**                                                       | ** ** | **For the period  from April 1  to April 27,** | ** ** | **Three Months  Ended  June 30,** | ** ** | **Three Months  Ended  June 30,** | ** ** | **Three Months  Ended  June 30,** | ** ** | **Three Months  Ended  June 30,** | ** ** | **Three Months  Ended  June 30,** | ** ** |
| **data)**                                            | ** ** | **2004**                          | ** ** | **2003**                          | ** ** | **2004**                                     | ** ** | **2003**                                                                                | ** ** | **2004**                                       | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                 |       |                              |       |                              |       |                                         |       |                                                                                    |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Pro forma adjusted net revenue                       |       | $                                 | 689,628    |                              | $          | 405,834                                      |       | $                                                                                       | 364        |                                           | $          | 510 |   | $ | 953 |   | $ | 5,780 |   |   |   |   |   | $ | 690,945 |   | $ | 412,124 |   |
| Pro forma adjusted net income (loss)                 |       | $                                 | 43,863     |                              | $          | 39,412                                       |       | $                                                                                       | (1,695     | )                                              | $          | (3,095 | ) | $ | (276 | ) | $ | (2,134 | ) | $ | (792 | ) | $ | (1,331 | ) | $ | 41,100 |   | $ | 32,852 |   |
| Pro forma adjusted basic earnings (loss) per share   |       | $                                 | 0.39       |                              | $          | 0.39                                         |       |                                                                                    |       |                                           |       |   |   |   |   |   |   |   |   | $ | 0.36 |   | $ | 0.33 |   |
| Pro forma adjusted diluted earnings (loss) per share |       | $                                 | 0.33       |                              | $          | 0.33                                         |       |                                                                                    |       |                                           |       |   |   |   |   |   |   |   |   | $ | 0.31 |   | $ | 0.27 |   |
|                                                      |            |                                   |            |                                   |            |                                              |            |                                                                                         |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                           | ** ** | **UT Starcom, Inc.** | ** ** | **TELOS Technology, Inc.** | ** ** | **Hyundai Syscomm, Inc.** | ** ** | **Pro Forma adjustments to  reflect depreciation and  amortization of acquired assets** | ** ** | **Pro Forma Results** | ** ** |
|------------------------------------------------------|------------|----------------------|------------|----------------------------|------------|---------------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **Six Months**       | ** ** | **Six Months**             | ** ** | **For the period**        | ** ** | **Six Months**                                                                          | ** ** | **For the period**    | ** ** | **Six Months** | ** ** | **Six Months** | ** ** | **Six Months** | ** ** | **Six Months** | ** ** | **Six Months** | ** ** |
| **(In  thousands,**                                  | ** ** | **Ended**            | ** ** | **Ended**                  | ** ** | **from January 1**        | ** ** | **Ended**                                                                               | ** ** | **from January 1**    | ** ** | **Ended** | ** ** | **Ended** | ** ** | **Ended** | ** ** | **Ended** | ** ** | **Ended** | ** ** |
| **except  per**                                      | ** ** | **June 30,**         | ** ** | **June 30,**               | ** ** | **to May 19,**            | ** ** | **June 30,**                                                                            | ** ** | **to April 27,**      | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| **share  data)**                                     | ** ** | **2004**             | ** ** | **2003**                   | ** ** | **2004**                  | ** ** | **2003**                                                                                | ** ** | **2004**              | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                 |       |                 |       |                       |       |                      |       |                                                                                    |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Pro forma adjusted net revenue                       |       | $                    | 1,311,919  |                       | $          | 736,354                   |       | $                                                                                       | 1,689      |                  | $          | 1,842 |   | $ | 2,872 |   | $ | 11,252 |   |   |   |   |   | $ | 1,316,480 |   | $ | 749,448 |   |
| Pro forma adjusted net income (loss)                 |       | $                    | 98,629     |                       | $          | 76,755                    |       | $                                                                                       | (3,953     | )                     | $          | (6,177 | ) | $ | (4,548 | ) | $ | (7,518 | ) | $ | (2,123 | ) | $ | (2,662 | ) | $ | 88,005 |   | $ | 60,398 |   |
| Pro forma adjusted basic earnings (loss) per share   |       | $                    | 0.86       |                       | $          | 0.74                      |       |                                                                                    |       |                  |       |   |   |   |   |   |   |   |   | $ | 0.77 |   | $ | 0.58 |   |
| Pro forma adjusted diluted earnings (loss) per share |       | $                    | 0.73       |                       | $          | 0.65                      |       |                                                                                    |       |                  |       |   |   |   |   |   |   |   |   | $ | 0.65 |   | $ | 0.52 |   |
|                                                      |            |                      |            |                            |            |                           |            |                                                                                         |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

15

----

 

*Audiovox Communications, Inc.*

 

On June 14, 2004, the Company announced an agreement to acquireselect assets of Audiovox Communications Corporation, the wireless handsetdivision of Audiovox Corporation. The Company will acquire select assets andliabilities, including inventories, prepaids, third-party payables, accruedexpenses and the right to hire approximately 270 employees for $165.1 millionin cash. The Company will acquire Audiovox Communications Corporation’s sales,service and support infrastructure, its CDMA handset brand, access tosupply-chain channels, product marketing expertise and key relationships withCDMA operators in North and South America. Closing of the transaction issubject to satisfaction of certain conditions outlined in the purchaseagreement. The Company anticipates closing to occur in the fourth quarter of2004.

 

**12.****                               GOODWILLAND INTANGIBLE ASSETS:**

 

As of June 30, 2004 and December 31, 2003, goodwill and otheracquired intangible assets consisted of the following (in thousands):

 
| **(in  thousands)**              | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | ** **             | ** ** | ** **                 | ** ** |
| Goodwill                         |       | $                      | 126,252    |                       | $          | 113,003 |   |
| Less accumulated amortization    |       | (12,823                | )          | (12,823                    | )          |
|                             |       | $                      | 113,429    |                       | $          | 100,180 |   |
|                             |       |                   |       |                       |       |
| *Identified  intangible assets:* |       |                   |       |                       |       |
|                             |       |                   |       |                       |       |
| Existing technology              |       | $                      | 43,089     |                       | $          | 23,630 |   |
| Less accumulated amortization    |       | (10,630                | )          | (7,254                     | )          |
|                             |       | $                      | 32,459     |                       | $          | 16,376 |   |
|                             |       |                   |       |                       |       |
| Customer relationships           |       | $                      | 32,820     |                       | $          | 27,820 |   |
| Less accumulated amortization    |       | (3,097                 | )          | (1,623                     | )          |
|                             |       | $                      | 29,723     |                       | $          | 26,197 |   |
|                             |       |                   |       |                       |       |
| Trade names                      |       | $                      | 940        |                       | $          | 940 |   |
| Less accumulated amortization    |       | (509                   | )          | (274                       | )          |
|                             |       | $                      | 431        |                       | $          | 666 |   |
|                             |       |                   |       |                       |       |
| Backlog                          |       | $                      | 1,950      |                       | $          | 1,950 |   |
| Less accumulated amortization    |       | (1,950                 | )          | (1,137                     | )          |
|                             |       | $                      | —     |                       | $          | 813 |   |
|                             |       |                   |       |                       |       |
| Non-compete agreement            |       | $                      | 760        |                       | $          | - |   |
| Less accumulated amortization    |       | (42                    | )          | —                     |       |
|                             |       | $                      | 718        |                       | $          | — |   |
|                             |       |                   |       |                       |       |
| Royalty licenses                 |       | $                      | 890        |                       | $          | - |   |
| Less accumulated amortization    |       | (30                    | )          | —                     |       |
|                             |       | $                      | 860        |                       | $          | — |   |
|                             |       |                   |       |                       |       |
| Total intangible assets          |       | $                      | 64,191     |                       | $          | 44,052 |   |

 

Amortization expense was $3.5 million and $1.5 million for thethree months ended June 30, 2004 and 2003, respectively, and was $6.0million and $2.2 million for the six months ended June 30, 2004 and 2003,respectively. The estimated aggregate amortization expense for intangibles foreach of the five years beginning the year ended December 31, 2005 through2009 is $12.1 million, $11.0 million, $10.8 million,$9.0 million and $4.8 million. 

 

16

----

 

The net increase in goodwill during the six months ended June 30,2004 was $13.3 million, due to a $13.4 million increase from $6.6 million and$6.8 million of goodwill recorded on the acquisitions of TELOS and HSI,respectively, offset by a $0.1 million reduction in goodwill resulting from thesettlement of an outstanding liability related to the CommWorks acquisition for$0.1 million less than had been accrued. Intangibles increased by $26.1 millionduring the six months ended June 30, 2004 due to $20.9 million and $5.2million of intangibles recorded on the acquisitions of TELOS and HSI,respectively.  

 

The estimated useful life of purchased technology is from one to fiveyears, the estimated useful life of customer relationships is five years to tenyears, the estimated useful life of non-compete agreements is three years, theestimated useful lives of backlog and trade names are from one to two years andthe estimated useful lives of royalty licenses are five years.

 

**13.****                               LONG-TERMINVESTMENTS:**

 

The Company’s investments are as follows (in thousands):

 
| ** **                                  | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|---------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| Softbank China                              |       | $                      | 5,294      |                       | $          | 5,308 |   |
| Cellon International                        |       | 8,000                  |       | 8,000                      |       |
| Restructuring Fund No. 1                    |       | 1,838                  |       | 1,861                      |       |
| Global Asia Partners L.P.                   |       | 1,150                  |       | 1,653                      |       |
| Fiberxon Inc.                               |       | 3,000                  |       | 2,000                      |       |
| InterWave Communications International Ltd. |       | 3,678                  |       | 3,319                      |       |
| Joint Venture with Matsushita               |       | —                 |       | 517                        |       |
| Others                                      |       | 1,544                  |       | 1,408                      |       |
|                                        |       |                   |       |                       |       |
| Total                                       |       | $                      | 24,504     |                       | $          | 24,066 |   |

 

*Softbank China*

* *

The Company has a $5.3 million investment in Softbank China, aninvestment fund established by SOFTBANK CORP. focused on investments inInternet companies in China. This investment is intended to enable the Companyto participate in the anticipated growth of Internet-related businesses inChina. SOFTBANK CORP. and its related companies are significant stockholders ofthe Company. The Company’s investment constitutes 10% of the funding forSoftbank China, with SOFTBANK CORP. contributing the remaining 90%. The fundhas a separate management team, and none of the Company’s employees areemployed by the fund. Many of the fund’s investments are and will be inprivately held companies, many of which are still in the start-up ordevelopment stages. These investments are inherently risky as the markets forthe technologies or products the companies have under development are typicallyin the early stages and may never materialize. The Company accounts for thisinvestment under the cost method and recorded no losses and insignificantlosses in the carrying value of this investment during the three and six monthsended June 30, 2004, respectively. The Company recorded insignificantlosses and losses of $0.1 million due to an other-than-temporary decline in thecarrying value of this investment during the three and six months endedJune 30, 2003, respectively.

 

*Cellon*

 

In September 2001, the Company invested $2.0 million in CellonInternational Holdings Corporation (“Cellon”). Cellon designs wirelessterminals and related technology for handset manufacturers and privatedistributors. The Company invested an additional $3.0 million ineach of April and December 2002. As of June 30, 2004, theCompany had a 9% ownership interest in Cellon. This investment is accounted forunder the cost method, and its carrying value is evaluated for possibleimpairment based on the achievement of business objectives and milestones, thefinancial condition and prospects of the company and other relevant factors. Asof June 30, 2004, the Company has not recorded any impairment of thisinvestment. The Company has outstanding purchase commitments with Cellon. Referto Note 19, Related Party Transactions.

 

*Restructuring Fund No. 1*

 

During fiscal 2002, the Company invested $2.0 million inRestructuring Fund No. 1, a venture capital investment limited partnershipestablished by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANK CORP.SOFTBANK

 

17

----

 

America Inc., an entity affiliated with SOFTBANK CORP., is asignificant stockholder of the Company. The fund focuses on leveraged buyoutinvestments in companies in Asia undergoing restructuring or bankruptcyprocedures. The total fund offering is expected to be between approximately$150.0 million and $226.0 million, with each investor contributing aminimum of $0.8 million. The fund has a separate management team, and noneof the Company’s employees are employed by the fund. The Company accounts forthis investment under the equity method of accounting.  There were no gains or losses andinsignificant losses during the three and six months ended June 30, 2004,respectively.

 

*Global Asia Partners, L.P.*

 

In June 2002, the Company invested $1.0 million in GlobalAsia Partners L.P., and an additional $1.0 million in June 2003, witha commitment to invest up to a maximum of $5.0 million. The remainingamount is due at such times and in such amounts as shall be specified in one ormore future capital calls to be issued by the general partner. The fund size isanticipated to be $10.1 million and the fund was formed to make privateequity investments in private or pre-IPO technology and telecommunicationscompanies. The fund’s geographic focus is on technology investments in Asia, inparticular India and China. The Company accounts for this investment under theequity method of accounting. There were $0.5 million of losses for the threeand six months ended June 30, 2004 and no gains or losses for the threeand six months ended June 30, 2003.

 

### *Fiberxon*

### * *

In September 2002, the Company invested $2.0 million in Fiberxon,Inc., a company that develops and sells optical modules and related systems. InMarch 2004, the Company invested an additional $1.0 million in Fiberxon.This investment is accounted for under the cost method, and its carrying valueis evaluated for possible impairment based on the achievement of businessobjectives and milestones, the financial condition and prospects of the companyand other relevant factors. As of June 30, 2004, the Company has notrecorded any impairment in respect of this investment. The Company hasoutstanding purchase commitments with Fiberxon. Refer to Note 19, Related PartyTransactions.

 

*Interwave*

 

During 2002, the Company purchased approximately 5.8 millionshares of common stock of InterWave Communications, InternationalLtd. Inc., a technology company listed on Nasdaq, for approximately$3.0 million. In addition, the Company received warrants to purchase2.0 million shares of InterWave’s common stock at $0.21 per share. TheCompany’s holdings were adjusted for a 1:10 reverse stock split onApril 30, 2003, and were 0.6 million shares of common stock andwarrants to purchase 0.2 million shares of InterWave’s common stock at $2.10per share. The fair value of Company’s common stock investment in InterWave was$3.0 million as of June 30, 2004. Changes in the fair value of the stockare reflected in other comprehensive income in equity as unrealized gains orlosses. The Company recorded increases of $0.7 million and $0.6 million for thethree months ended June 30, 2004 and 2003, respectively, in othercomprehensive income in equity.  TheCompany recorded increases of $0.4 million for both the six months endedJune 30, 2004 and 2003, respectively in other comprehensive income inequity. The warrants were valued at $0.7 million at June 30, 2004,using the Black-Scholes option-pricing model. The Company recorded income of$0.2 million for both the three months ended June 30, 2004 and 2003, toreflect the change in the fair value of the warrants. The Company recordedinsignificant losses for the six months ended June 30, 2004 and income of$0.2 million for the six months ended June 30, 2003, to reflect the changein the fair value of the warrants. On July 27, 2004, Alvarion, Ltd. agreedto acquire InterWave for $5.75 per share. 

 

*Matsushita*

 

In July, 2002, the Company entered into a joint venture agreement withMatsushita Communication Industrial Co., Ltd., a stockholder of theCompany, to jointly design and develop, manufacture and sell telecommunicationproducts. The Company has a 49% ownership interest in the joint venturecompany, which has a registered share capital of $10.0 million. The cashconsideration of $4.9 million payable by the Company was paid inOctober 2002. As the Company does not have voting control over significantmatters of the joint venture company, the investment in and results ofoperations of the joint venture company are accounted for using the equitymethod of accounting.

 

Pursuant to the joint venture agreement with Matsushita, the Company isjointly liable for the losses incurred in the operations of the joint ventureup to the maximum of its investment in the entity. At June 30, 2004, the losseshad exceeded this amount; however, the Company accrued additional losses ofapproximately $1.2 million and $2.2 million during the three and six monthsended June 30, 2004, respectively. The Company has cumulative losses of $2.2million recorded within other current liabilities. The Company has committed tofunding an additional $9.3 million during the fiscal year 2004.

 

*Other investments*

 

The Company has also invested directly in a number of privatetechnology-based companies in the early stages of development. Theseinvestments are accounted for on the cost basis. The Company continuallyevaluates the carrying value of these investments for possible impairment basedon the achievement of business objectives and milestones, the financial

 

18

----

 

condition and prospects of these companies and other relevant factors.During the three and six months ended June 30, 2004 and 2003, there wereno valuation adjustments in respect of these private technology investments.The Company also invests in publicly traded technology-based companies andaccounts for these as available-for-sale securities on a fair market valuebasis. There were insignificant changes in the value of these investments forthe three and six months ended June 30, 2004 and 2003.

 

In July 2004, the Company invested $3.0 million in Series DPreferred Stock, for approximately a 2% ownership interest, in Infinera, Corp.,a company that develops and manufactures optical networking systems.

 

**14.****                               DEBT:**

 

The following represents the outstanding borrowings at June 30,2004 and December 31, 2003 (in thousands):

 
| **Note**                       | ** ** | **Rate** | ** ** | **Maturity**             | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|--------------------------------|------------|----------|------------|--------------------------|------------|------------------------|------------|----------------------------|------------|
| Notes Payable                  |       | 0%       |       | July-September 2004 |       | $                      | 1,500      |                       | $          | 1 |   |
| Convertible Subordinated Notes |       | 7/8%     |       | March 1, 2008       |       | 402,500                |       | 402,500                    |       |
| Total Debt                     |       |     |       |                     |       | $                      | 404,000    |                       | $          | 402,501 |   |
| Long-term debt                 |       |     |       |                     |       | 402,500                |       | 402,500                    |       |
| Short-term debt                |       |     |       |                     |       | $                      | 1,500      |                       | $          | 1 |   |

 

Occasionally, the Company issues short-term notes payable to itsvendors in lieu of trade accounts payable. The payment terms are normally three to six months and are typicallynon-interest bearing.  The Company had$1.5 million of these notes at June 30, 2004 included in other currentliabilities.

 

The Company has available borrowing facilities of $566.8 million as ofJune 30, 2004. $264.8 million of these facilities expire in 2004 and$302.0 million of these facilities expire between 2008 and 2010 with aninterest rate of 5.31%, and the Company has not guaranteed any debt notincluded in the consolidated balance sheet.

 

On March 12, 2003, the Company completed anoffering of $402.5 million of convertible subordinated notes dueMarch 1, 2008 to qualified buyers pursuant to Rule 144A under theSecurities Act of 1933. The notes bear interest at a rate of 7/8% per annum andare convertible into the Company’s common stock at a conversion price of $23.79per share and are subordinated to all present and future senior debt of theCompany. Holders of the notes may convert their notes only if: (i) theprice of the Company’s common stock issuable upon conversion of a note reachesa specified threshold, (ii) specified corporate transactions occur, or(iii) the trading price for the notes falls below certain thresholds. Atthe initial conversion price, each $1,000 principal amount of notes will beconvertible into approximately 42.0345 shares of common stock. Expensesassociated with the convertible subordinated notes issuance were $11.1 millionand have been recorded with in other long-term assets and are being amortizedover the life of the notes.

 

Concurrent with the issuance of the convertible notes, the Companyentered into a convertible bond hedge and call option transaction at a cost of$43.8 million. The convertible bond hedge allows the company to purchase16,918,873 shares of its common stock at $23.79 per share from the other partyto the agreement. The written call option allows the holder to purchase16,918,873 shares of the Company’s common stock from the Company at $32.025 pershare. Both the bond hedge and call option transactions may be settled at theCompany’s option either in cash or net shares and expire on March 1, 2008.The Company recorded these instruments at cost, and their carrying value atJune 30, 2004 approximates their original cost. The convertible bond hedgeand call option transactions are expected to reduce the potential dilution fromconversion of the notes. The options have been included in stockholders’ equityin accordance with the guidance in Emerging Issues Task Force IssueNo. 00-19, “Accounting for Derivative Financial Instruments Indexed to,and Potentially Settled in, a Company’s Own Stock.”

 

**15.****                               WARRANTYOBLIGATIONS AND OTHER GUARANTEES:**

 

Warranty obligations are as follows (in thousands):

 

19

----

 
| ** **                                        | ** ** | **Three months ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                        | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                              |       |                                 |       |                               |       |   |   |   |   |
| Beginning of period                               |       | $                                    | 29,524     |                               | $          | 12,524 |   | $ | 26,267 |   | $ | 13,297 |   |
| Accruals for warranties issued during the  period |       | 15,714                               |       | 8,427                              |       | 25,555 |   | 16,710 |   |
| Adjustments to accruals for changes in  estimates |       | (622                                 | )          | —                             |       | (455 | ) | (4,552 | ) |
| Settlements made during the period                |       | (10,380                              | )          | (4,523                             | )          | (17,131 | ) | (9,027 | ) |
| Balance at end of period                          |       | $                                    | 34,236     |                               | $          | 16,428 |   | $ | 34,236 |   | $ | 16,428 |   |

 

### *Warranty obligations:*

 

Certain of the Company’s sales contracts include provisions under whichcustomers would be indemnified by the Company in the event of, among otherthings, a third-party claim against the customer for intellectual propertyrights infringement related to the Company’s products. There are no limitationson the maximum potential future payments under these guarantees. The Companyhas accrued no amounts in relation to these provisions as no such claims havebeen made and the Company believes it has valid, enforceable rights to the intellectualproperty embedded in its products.

 

*Standby letters of credit:*

 

The Company issues standby letters of credit primarily to supportinternational sales activities outside of China. When the Company submits a bidfor a sale, often the potential customer will require that the Company issue abid bond or a standby letter of credit to demonstrate its commitment throughthe bid process. In addition, the Company may be required to issue standbyletters of credit as guarantees for advance customer payments upon contractsigning or performance guarantees. The standby letters of credit usually expiresix to nine months from date of issuance without being drawn by the beneficiarythereof. The Company may issue commercial letters of credit in support of purchasecommitments.

 

**16.****                               COMMITMENTSAND CONTINGENCIES:**

 

*Joint Venture Funding:*

 

Pursuantto the joint venture agreement with Matsushita, the Company is jointly liablefor the losses incurred in the operations of the joint venture up to themaximum of its investment in the entity. At June 30, 2004, the losses had exceeded this amount; however, theCompany had accrued additional losses of approximately $1.2 million and $2.2million during the three and six months ended June 30, 2004 due to itscommitment to fund an additional investment of $9.3 million during the fiscalyear 2004.

 

*Investment Commitments:*

 

As of June 30, 2004, theCompany had invested a total of $2.0 million in Global Asia Partners L.P.The fund size is anticipated to be $10.1 million and the fund was formedto make private equity investments in private or pre-IPO technology andtelecommunications companies in Asia. The Company has a commitment to invest upto a maximum of $5.0 million. The remaining amount is due at such timesand in such amounts as shall be specified in one or more future capital callsto be issued by the general partner.

 

*Purchase Commitments:*

 

The Company is obligated to purchase raw materials and work-in-processinventory under various orders from three suppliers, all of which should befulfilled without adverse consequences material to the operations or financialcondition of the Company. As of June 30, 2004, total open commitmentsunder these purchase orders were approximately $39.6 million, including $16.9million of open purchase orders with Fiberxon.

 

*Litigation:*

 

On October 31,2001, a complaint was filed in United States District Court for the SouthernDistrict of New York against the Company, some of its directors and officersand various underwriters for its initial public offering. Substantially similaractions were filed concerning the initial public offerings for more than 300different issuers, and the cases were coordinated as *In re Initial Public Offering Securities Litigation*, 21 MC92. In April 2002, a consolidated amended complaint

 

20

----

 

was filed in the matter againstthe Company, captioned *In re UTStarcom,Initial Public Offering Securities Litigation*, Civil Action No.01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and theSecurities Exchange Act of 1934 through undisclosed improper underwritingpractices concerning the allocation of IPO shares in exchange for excessivebrokerage commissions, agreements to purchase shares at higher prices in theaftermarket, and misleading analyst reports. Plaintiffs seek unspecifieddamages on behalf of a purported class of purchasers of the Company’s commonstock between March 2, 2000 and December 6, 2000. The Company’s directors andofficers were dismissed without prejudice pursuant to a stipulation. OnFebruary 19, 2003, the Court granted in part and denied in part a motion todismiss brought by defendants including the Company. The order dismissed allclaims against the Company except for a claim brought under Section 11 of theSecurities Act of 1933, which alleges that the Company’s initial publicoffering registration statement contained untrue statements of material factand omitted to state material facts required to be stated in the registration statement,or necessary to make the statements therein not misleading.

 

In June 2004, a stipulationof settlement and release of claims against the issuer defendants, includingthe Company, was submitted for preliminary approval by the Court. Under thesettlement, the plaintiffs would dismiss and release all claims againstparticipating defendants in exchange for a contingent payment undertaking bythe insurance companies collectively responsible for insuring the issuerdefendants in the coordinated action, and the assignment or surrender to theplaintiffs of certain claims the issuer defendants may have against theunderwriters. Pursuant to the undertaking, the insurers would be required topay the amount, if any, by which $1.0 billion exceeds the total amountultimately collected by the plaintiffs from the non-settling defendants in thecoordinated action. The settlement is subject to a number of conditionsincluding Court approval.

 

If the settlement does notoccur, and litigation against UTStarcom continues, the Company believes it hasvalid defenses and intends to defend the case vigorously. The Company is unableto currently estimate the loss, if any, associated with the above litigation.

 

The Company has filed apatent infringement suit against Starent Networks Corporation (“Starent”) inthe U.S. District Court for the Northern District of California.  In its Complaint, the Company asserts thatStarent infringes two UTStarcom patents through the manufacture, offer forsale, and sale of Starent’s ST-16 Intelligent Mobile Gateway.  On June 3, 2004, the Company served itscomplaint on Starent.  On July 30,2004, Starent filed and served its answer and counterclaims.  In its counterclaims, Starent asserts thatthe patents are not infringed, are invalid, and are unenforceable and assertsunfair competition against the Company. The Court is scheduled to hold an initial case management conference onOctober 12, 2004.  Although the Companycannot reliably predict the outcome of this litigation, it believes that anyliability arising from Starent’s counterclaims will not have a material adverseeffect on the business, financial condition, or results of operations of theCompany.

 

The Company is a party to other litigation matters and claims that arenormal in the course of operations, and while the results of such litigationmatters and claims cannot be predicted with certainty, the Company believesthat the final outcome of such matters will not have a material adverse impacton its financial position or results of operations.

 

**17.****                               STOCKHOLDERS’EQUITY:**

 

On January 14, 2004, the Company sold 12.1 million shares ofcommon stock at $39.25 per share in a privately negotiated transaction to aninstitution, for net proceeds of approximately $474.6 million. The netproceeds are intended to fund strategic and general corporate activities,including, but not limited to, acquisitions, investments, working capital orcapital expenditures.

 

On March 12, 2004, the Company’s Board of Directors approved astock repurchase program, authorizing the Company’s repurchase of up to5,000,000 shares of its outstanding common stock over a period of 6 months. TheBoard approved an additional repurchase of 1,623,000 shares in a privatelynegotiated transaction with an institution which was completed in March2004.  As of June 30, 2004, theCompany repurchased a total of approximately 3.6 million shares at a weightedaverage price of $30.25 per share, for a total cash outflow of $107.6 million.

 

For the three months ended June 30, 2004 and 2003, the Company had$8.3 million and $30.9 million of net proceeds from the exercise ofstock options, respectively. For the six months ended June 30, 2004 and2003, the Company had $17.6 million and $35.0 million of net proceedsfrom the exercise of stock options, respectively. Additionally, the Companyissued 32,000 shares of common stock pursuant to the exercise of a warrant atan exercise price of $2.50 per share for proceeds of $0.1 million during thesecond quarter of 2004.

 

**18.****                               SEGMENTREPORTING:**

 

The Company sells wireless, wireline and switching product suites totelecommunications service providers in both emerging growth and establishedtelecommunications markets around the world. The Company primarily operates intwo geographic areas, China and other regions. The chief operating decisionmakers evaluate performance, make operating decisions, and allocate resourcesbased on consolidated financial data. Gross profit, operating income, incomefrom operations, and income taxes are not allocated to specific individualdepartments within the organization. In accordance with SFAS No. 131“Disclosures about Segments of an Enterprise and Related Information,” theCompany is considered a single

 

21

----

 

reportable segment. The Company is required to disclose certaininformation about product revenues, information about geographic areas,information about major customers, and information about long-lived assets.

 

China sales accounted for 90% and 91% of net sales for the three andsix months ended June 30, 2004, respectively, and 82% of net sales forboth the three and six months ended June 30, 2003. The Company groups allof its China customers together by province and treats each province as onecustomer since that is the level at which purchasing decisions are made. AtJune 30, 2004 and 2003, there were approximately 30 and 31 such customers,respectively. Giving effect to this consolidation, the Jiangsu and Hei LongJiang provinces accounted for 15% and 10% of net sales, respectively, for thethree months ended June 30, 2004. The Hei Long Jiang, Zhejiang and Hebeiprovinces accounted for 13%, 11% and 10% of net sales, respectively, for thethree months ended June 30, 2003. The Guangdong, Jiangsu and Hei LongJiang provinces accounted for 16%, 11% and 10%, of net sales, respectively, forthe six months ended June 30, 2004. The Hei Long Jiang province accountedfor 13% of net sales for the six months ended June 30, 2003.

 

Geographical area and product sales data are as follows (in thousands):

 
| ** **                 | ** ** | **Three months ended June 30,** | ** **  | **Six months ended June 30,** | ** ** |
|----------------------------|------------|--------------------------------------|-------------|------------------------------------|------------|
| ** **                 | ** ** | **2004**                             | ** **  | ** **                         | ** ** | **2003** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **(in thousands)**                   | ** **  |
| **Sales by region**        | ** ** | ** **                           | ** **  | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| China                      |       | $                                    | 618,323     |                               | 90         | % | $ | 332,548 |   | 82 | % | $ | 1,188,889 |   | 91 | % | $ | 601,478 |   | 82 | % |
| Japan                      |       | 22,104                               |        | 3                                  | %          | 60,546 |   | 15 | % | 41,531 |   | 3 | % | 120,366 |   | 16 | % |
| Other                      |       | 49,201                               |        | 7                                  | %          | 12,740 |   | 3 | % | 81,499 |   | 6 | % | 14,510 |   | 2 | % |
| **TOTAL NET SALES**        |       | **$**                                | **689,628** |                               | 100        | % | **$** | **405,834** |   | 100 | % | **$** | **1,311,919** |   | 100 | % | **$** | **736,354** |   | 100 | % |
|                       |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Sales by product  line** |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Wireless infrastructure    |       | $                                    | 427,659     |                               | 62         | % | $ | 143,490 |   | 35 | % | $ | 764,176 |   | 58 | % | $ | 267,850 |   | 36 | % |
| Subscriber handsets        |       | 194,313                              |        | 28                                 | %          | 187,128 |   | 46 | % | 430,733 |   | 33 | % | 327,088 |   | 44 | % |
| Wireline products          |       | 67,656                               |        | 10                                 | %          | 75,216 |   | 19 | % | 117,010 |   | 9 | % | 141,416 |   | 20 | % |
| **TOTAL NET SALES**        |       | **$**                                | **689,628** |                               | 100        | % | **$** | **405,834** |   | 100 | % | **$** | **1,311,919** |   | 100 | % | **$** | **736,354** |   | 100 | % |

 

Long-lived assets by geography, consisting of property, plant andequipment, goodwill and intangible assets, are as follows (in thousands):

 
| ** **              | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------------|------------|
| U.S.                    |       | $                       | 143,894    |                        | $          | 155,241 |   |
| Foreign                 |       | 259,735                 |       | 175,067                     |       |
| Total long-lived assets |       | $                       | 403,629    |                        | $          | 330,308 |   |

 

**19.****                               RELATEDPARTY TRANSACTIONS:**

 

### *Softbank*

 

The Company recognized revenue of $21.1 million and $32.6 millionfor the three and six months ended June 30, 2004, respectively, and $60.2million and $118.7 million for the three and six months ended June 30,2003, respectively, with respect to sales of telecommunications equipment toSBBC, an affiliate of SOFTBANK America Inc., which is a significantstockholder of the Company. SBBC offers asynchronous digital subscriber line(“ADSL”) coverage throughout Japan, which is marketed under the name “YAHOOBB!”. The Company provides ADSL technology to SBBC. The contract wascompetitively bid and the terms of this contract were on terms no morefavorable than those with unrelated parties. Included in accounts receivable atJune 30, 2004 and December 31, 2003 were $29.9 million and$43.9 million, respectively, related to this agreement. There wereinsignificant amounts included in deferred revenue in respect of this agreementat June 30, 2004 and no amounts included in deferred revenue in respect ofthis agreement at December 31, 2003.

 

The Company has invested in Softbank China and Restructuring FundNo. 1, which are investment vehicles established by SOFTBANK CORP and itsaffiliates. See Note 13.

 

On July 17, 2003, the Company entered into a Mezzanine Loan Agreementwith BB Modem Rental PLC (“BB Modem”), an affiliate of SOFTBANK America, Inc.Under the terms of the agreement the Company loaned BB Modem $10.1 million atan effective interest rate of 12.01% per annum, for the purposes of investingin a portfolio of ADSL modems and associated modem rental agreements, from SOFTBANKBB CORP., formerly BB Technologies, an affiliate of SOFTBANK America, Inc.SOFTBANK BB CORP. will continue to service such modems and modem rentalagreements. The Company’s loan is subordinated to certain senior lenders of BBModem, and repayments are payable to the Company over a forty-two month periodthrough January 31, 2007, with a substantial portion of the principal amount ofthe loan schedule to be repaid during the last 16 months of this period. TheCompany’s recourse for nonpayment of the loan is limited to the assets of BBModem, the account into which subscriber payments are made and its rights underthe securitization transaction documents. The value of BB Modem’s modems thatserve as collateral for the loan may decrease over time and may not besufficient upon sale to pay the outstanding amounts on the loans. The Companyassesses the loan for impairment whenever events or changes in circumstancesindicate that the carrying amount may not be recoverable. The Companyperiodically reviews the underlying quality of the asset pool securing the loanto assess whether impairment has incurred and needs to be recorded. Duringthree and six months ended June 30, 2004, the Company recorded $0.3million and $0.7 million, respectively, in interest income in respect of thisloan. The loan receivable at June 30, 2004 was approximately $11.2 million andis included in other long-term assets.

 

22

----

 

On April 5, 2003, the Company repurchased 8.0 million sharesof common stock beneficially owned by SOFTBANK America Inc., at a purchaseprice of $17.385 per share. The total cost of the repurchase was$139.6 million including transaction fees. In connection with thisrepurchase transaction, SOFTBANK America Inc. entered into an agreementwith the Company not to offer, sell or otherwise dispose of the Company’scommon stock for a period of one year, subject to a number of exceptions. As ofJune 30, 2004, SOFTBANK America Inc. beneficially owned approximately12.9% of the Company’s outstanding stock.

 

### *Cellon*

### * *

In October 2002, the Company entered into a license and a royaltyagreement with Cellon International Holding Corporation (“Cellon”), in whichthe Company has a 9% ownership interest. The Company paid $0.8 million to licensecertain technology for the development of certain handset products in China.Per the terms of the royalty agreement, the Company is required to pay Cellon$3 per unit shipped for a minimum of 0.5 million units. This agreement is notmaterial to the overall financial results of Cellon. The Company has evaluatedits relationship with Cellon under FASB Interpretation ("FIN") 46,Consolidation of Variable Interest Entities, and determined that consolidationis not necessary.

 

### *Fiberxon*

### * *

The Company has an outstanding purchase commitment with Fiberxon, inwhich the Company has an 11% ownership interest, to purchase component partsfor optical networking products. In addition, the Company provided a letter ofcredit for $5.0 million to purchase raw materials for the manufacture of thesecomponent parts. This commitment should be fulfilled without adverseconsequences material to the operations or financial condition of the Company.As of June 30, 2004, total open commitments under these purchase orderswere $16.9 million, which are due at the end of this year.

 

**20.****                               COUNTRYRISKS:**

 

Approximately 90% and 91% of the Company’s net sales for the three andsix months ended June 30, 2004 and 82% for both the three and six monthsended June 30, 2003, respectively, were made in China. Accordingly, theCompany’s business, financial condition and results of operations are likely tobe influenced by the political, economic and legal environment in China and bythe general state of China’s economy. As such, the Company’s operations inChina are subject to special considerations and significant risks not typicallyassociated with companies in the United States. The Company’s results may beadversely affected by, among other things, changes in the political, economic,competitive and social conditions in China, including changes in governmentalpolicies with respect to laws and regulations, changes in China’stelecommunications industry and regulatory rules and policies,anti-inflationary measures, currency conversion and remittance abroad, andrates and methods of taxation.

 

Under China’s current regulatory structure, the communications productsthat the Company offers in China must meet government and industry standards,and a network access license for the equipment must be obtained. Without thelicense, the equipment may not be connected to public telecommunicationsnetworks or sold in China. Moreover, the Company must ensure that the qualityof the telecommunications equipment for which it has obtained a network accesslicense is stable and reliable, and may not lower the quality or performance ofother installed licensed products. China’s State Council’s product qualitysupervision department, in concert with China’s Ministry of InformationIndustry, performs spot checks to track and supervise the quality of licensedtelecommunications equipment and publishes the results of such spot checks.

 

Approximately 3%of the Company’s sales for both the three and six months ended June 30,2004 and approximately 15% and 16% of the Company’s sales for the three and sixmonths ended June 30, 2003, respectively, were made in Japan. Accordingly,the political, economic and legal environment and the general state of Japan’seconomy may influence the Company’s business, financial condition and resultsof operations.

 

**21.****                               INCOMETAX ASSETS AND LIABILITIES:**

 

In establishing its deferred income tax assets and liabilities, theCompany makes judgments and interpretations based on the enacted tax laws andpublished tax guidance applicable to its operations.  The Company recordsdeferred tax assets and liabilities and evaluates the need for valuationallowances to reduce the deferred tax assets to realizable amounts.  Thelikelihood of a material change in the Company’s expected realization of theseassets is dependent on future taxable income, its ability to use foreign taxcredit carryforwards and carrybacks, and the effectiveness of its tax planningstrategies

 

23

----

 

in the various relevant jurisdictions.  Changes to the Company’sincome tax provision or in the valuation of the deferred tax assets andliabilities may affect its annual effective income tax rate.

 

**22.****                               ACCOUNTINGFOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES:**

 

The Company uses derivative financial instruments to manage itsexposures to foreign currency exchange rate changes. The derivative instrumentsare accounted for pursuant to SFAS No. 133, “Accounting for DerivativeInstruments and Hedging Activities,” as amended by SFAS No. 138, “Accountingfor Certain Derivative Instruments and Certain Hedging Activities.” As amended,SFAS No. 133 requires that an entity recognize all derivatives as either assetsor liabilities on the balance sheet, measure those instruments at fair valueand recognize changes in the fair value of derivatives in earnings in theperiod of change unless the derivative qualifies as an effective hedge thatoffsets certain exposures. Such contracts are designated at inception to therelated foreign currency exposures being hedged. Beginning in the first quarterof 2004, the Company hedges certain of its Japanese Yen-denominated balancesheet exposures against future movements in foreign currency exchange rates byusing foreign currency forward contracts. Hedged transactions are denominatedin U.S. dollars on behalf of these transactions denominated in Japanese Yen.Pursuant to its foreign currency exchange hedging policy, the Company may hedgeanticipated transactions and the related payables denominated in foreign currenciesusing forward foreign currency exchange rate contracts.  Gains and losses on these fair value hedgesare intended to offset gains and losses from the revaluation of JapaneseYen-denominated recognized liabilities. The net result of these gains and losseson contracts and revaluation included in interest and other income (expense)was insignificant for the three and six months ended June 30, 2004. TheCompany’s foreign currency forward contracts generally mature within threemonths. These derivative financial instruments are not held for tradingpurposes. There were no foreign currency forward contracts open atJune 30, 2004.

 

**23.****                               RECENTACCOUNTING PRONOUNCEMENTS:**

 

In November 2003,the EITF issued EITF No. 03-6 “ Participating Securities and the Two-ClassMethod under FASB Statement No. 128,” which provides for a two-class method ofcalculating earnings per share computations that relate to certain securitiesthat would be considered to be participating in conjunction with certain commonstock rights. This guidance was applicable to the Company starting with thesecond quarter beginning April 1, 2004. The Company evaluated the impactof this pronouncement and determined that there was no effect on its financialstatements.

 

On April 9, 2004, the FASB issued FASB Staff Position (“FSP”) to SFAS 129-1, Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities to provide disclosure guidance for contingently convertible securities, including those instruments with contingent conversion requirements that have not been met and otherwise are not required to be included in the computation of diluted earnings per share. The FSP addresses concerns that disclosures relating to contingently convertible securities are inconsistent between companies or may be inadequate. FSP SFAS 129-1 states that to comply with the requirements of SFAS 129, the significant terms of the conversion features of the contingently convertible security should be disclosed to enable users of financial statements to understand the circumstances of the contingency and the potential impact of conversion.  The Company evaluated the impact of this pronouncement and has enhanced its disclosures as required. Refer to Note 3, Earnings Per Share.

 

**ITEM 2****—MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**FORWARD-LOOKING STATEMENTS**

 

This Report on Form 10-Q contains forward-looking statementswithin the meaning of the federal securities laws. These statements are basedon information that is currently available to management. We intend suchforward-looking statements to be covered by the safe harbor provisions of thePrivate Securities Litigation Reform Act of 1995, and we are including thisstatement for purposes of complying with those provisions. The forward-lookingstatements include, without limitation, those concerning the following: ourexpectations as to the nature of possible trends, including our expectationsabout continuing growth in the number of subscribers for telecommunicationsproducts in other countries in which we do business; our expectations regardingcontinued growth in our business and operations; our expectation that therewill be fluctuations in our overall gross profit, gross margin, product mix,quarter to quarter results, customer base and selling prices; our plans forexpanding the direct sales organization and our selling and marketing campaignsand activities; our expectation

 

24

----

 

that we may use our cash, debt or securities to acquire or invest incomplementary businesses, technologies or product offerings; our expectationsregarding trends in customer acceptance of our products; our expectation thatthere will be increases in selling, marketing, research and development, andgeneral and administrative expenses; our expectations regarding future growthof our business and operations; our expectations regarding our ability to takeadvantage of strategic investment opportunities; our expectation that we willcontinue to invest significantly in research and development; our expectationsregarding the status of products under development; our expectations about anticipated Sarbanes-Oxleycompliance costs and our compliance with that Act; our expectationsregarding our future investments; our expectations regarding our future levelsof cash and cash equivalents, as well as our expectation that existing cash andcash equivalents will be sufficient to finance our operations for theforeseeable future; our expectations regarding licensing requirements and ourability to receive licenses in China for our PAS system and other products; ourexpectations regarding the development of 3G networks; our expectations regardingthe impact of a reorganization of China Netcom International Corporation Ltd.(“China Netcom”); our expectation that our business will continue to besignificantly influenced by the political, economic and legal environment inChina, as well as expectations about the nature of political, economic andlegal reform in China; our expectations regarding the future allocation of netsales by product group; our expectations regarding efficiencies we hope toachieve in supply chain management and inventory purchasing, as well as trendsin inventory growth; and our expectations regarding our expansion into newmarkets around the world. Additional forward-looking statements may beidentified by the words, “anticipate,” “expect,” “believe,” “intend,” “will”and similar expressions, as they relate to us or our management. Investors arecautioned that these forward-looking statements are inherently uncertain. Thesestatements are subject to risks and uncertainties that may cause actual resultsand events to differ materially. For a detailed discussion of these risks anduncertainties, see the “Factors Affecting Future Operating Results”section of this Form 10-Q. We do not guarantee future results andundertake no obligation to update the forward-looking statements to reflectevents or circumstances occurring after the date of this Form 10-Q.

 

## **EXECUTIVE SUMMARY**

 

We design, manufacture and sell telecommunications equipment andproducts and provide services associated with their operation. Our products aredeployed and installed globally primarily by wireless and wirelinetelecommunications service providers. We provide an extensive range of productsfor transportation of voice, data and video traffic for these serviceproviders. We are currently operating in China, Japan, India, the Central andLatin American region, North America, the European, Middle Eastern and Africanregion and southeastern and northern Asia. 

 

We differentiate ourselves withproducts designed to reduce network complexity, integrate high performance capabilitiesand allow a simple transition to next generation networks. We design ourproducts to facilitate cost-effective and efficient deployment, maintenance andupgrades. 

 

Our technologies and products fall into these major categories:

 

•                                          wirelessinfrastructure, a technology that enables end users, or subscribers, to sendand receive data, voice and media while mobile and using wireless devices;

 

•                                          wirelineinfrastructure, a technology that enables subscribers to send and receive data,voice and media transport and carriage in a fixed location; and

 

•                                          subscriberterminal products, including handsets and customer premise equipment (“CPE”),which receive data, voice and media transmissions.

 

Historically,substantially all of our sales have been to service providers in China. 90% and91% of our sales for the three and six months ended June 30, 2004,respectively, were derived from China. For the three and six monthsended June 30, 2004, we had $618.3 million and $1.2 billion of revenue,respectively, an 86% and 98% increase over the corresponding periods in 2003.This growth in revenue was driven by China’s continued demand for our productsand services to meet the needs of its increased subscriber base and itsexpanding telecommunications market. We use subscriber growth statistics togauge future inventory purchasing requirements as well as to forecast ouranticipated revenue growth. We expect this subscriber growth to continuethroughout 2004 since China’s teledensity rates, or the number oftelephones per person in a region, remain low in comparison to that ofdeveloped countries. However, we do expect this growth to be at a slower ratethan the first half of the year.

 

The number of competitors forcommunications access and switching systems and handsets in China has grown inline with China’s growing telecommunications market. This growth has led tocompetitive pricing pressure, causing average selling prices to decrease duringthe three and six months ended June 30, 2004 relative to those in the comparativeperiod in 2003. This pricing pressure affected both our infrastructure andhandset product lines, contributing to lower margins overall.

 

25

----

 

We strive to develop products with more advanced features and toenhance the features of our existing products, which we believe will enable usto offer our customers more advanced products at higher average selling pricesthan otherwise would be possible in the future sale. In addition, during thefirst half of 2004, we continued to strive to reduce the cost of manufacturingour products by streamlining our design functions.

 

During the second quarter 2004, wesigned approximately $300 million of international sales contracts, and weintend to continue to expand our global sales outside of China. We expect torecognize the majority of revenue from these contracts during the second halfof 2004. International deployments for the second quarter of 2004 were delayedby longer-than-average delivery times. As we expand, we need to improve oursupply chain and inventory management processes to ensure timely deliveries. Weengaged consultants to assist with these efforts, and expect to reduce ourdelivery times as a result of these improvements. 

 

# ***KEY TRANSACTIONS***

 

### ***Acquisitions***

 

During the second quarter of 2004, we closed two acquisitions andannounced a third acquisition with Audiovox, which we anticipate will close inthe fourth quarter of 2004.  We considerall three of these acquisitions to be important elements of our long-termglobal wireless strategy. Specifically, they provide the core features of ournew code division multiple access (or "COMA") product portfolio. 

 

# *TELOSTechnology, Inc.*

 

On May 19, 2004,we completed the acquisition of substantially all of the assets and certainliabilities of TELOS Technology, Inc. (“TELOS”) and its subsidiaries.  TELOS is a provider of mobile switchingproducts and services for voice and data communication networks to developingrural, enterprise and emerging wireless markets. The total consideration forthe acquisition, funded from cash on hand, was approximately $30.3million.  We paid $29.0 million in cash,in addition to $1.3 million of acquisition-related transaction costs. Withinone year of the acquisition date, additional payments totaling a maximum of$19.0 million may become payable based upon revenue recognized from the sale ofTELOS products. In the event these revenue milestones are met, the originalpurchase price will be adjusted for the amount of the contingent payment inaccordance with Statement of Financial Accounting Standards No. 141 (“SFAS141”), “Business Combinations.”

 

The existingtechnology acquired included the entire TELOS product family of CDMA softswitchtechnology products, supporting servers and operations maintenance centers.CDMA technology is the common platform on which third-generation wireless dataservices and applications are built. By assigning unique codes to eachcommunication to differentiate it from others in the same spectrum, CDMA technologyallows many users to occupy the same time and frequency allocations in a givenband or space. The TELOS product line will be integrated with our suite of CDMAproducts, strengthening our existing CDMA product and infrastructure portfolio.In addition to developed product technology, the Company acquired fixed assets,in-process research and development (“IPR&D”), an assembled workforce ofapproximately 60 employees, customer relationships and goodwill.

 

*Hyundai Syscomm, Inc.*

 

On April 27,2004, we completed the acquisition of the assets, substantially all of theintellectual property, certain employees and certain contracts related toHyundai Syscomm, Inc.’s (“HSI”) CDMA infrastructure business for marketsoutside of Korea.  Subject to theattainment of certain milestones and the transfer of certain know-how, thetotal consideration for this transaction was approximately $12.3 million,excluding transaction costs of $1.8 million. There was $7.3 million in cashpayable at the closing date and an additional $3.0 million in cash payable oneyear from the closing date. The remaining purchase price was comprised of $2.0million payable upon the completion of technical training by HSI employees toour manufacturing staff in China under the terms of a Training ServicesAgreement and $1.8 million of transaction costs. Not included in the purchaseprice was $2.0 million payable upon the completion of certain revenuemilestones. In the event these revenue milestones are met, the originalpurchase price will be adjusted for the amount of the contingent payment inaccordance with SFAS 141. 

 

Under theterms of the transaction with HSI, we acquired existing technologies andentered into non-compete and licensing agreements. The existing technologiesacquired were the base transceiver station (“BTS”) and base station controllers(“BSC”) product lines.  BTS is theantenna and radio equipment that enables wireless devices to communicate

 

26

----

 

with a land-based transmission network in a given range. BSC performsradio signal management functions for BTS, managing functions such as frequencyassignment and handoff. As part of the asset purchase agreement, we enteredinto a training services agreement with HSI, whereby HSI employees will providetechnical training to our manufacturing staff in China for the sixth-monthperiod subsequent to the acquisition. This technology and technologicalknow-how will strengthen our CDMA existing product portfolio and thedevelopment of future CDMA technology.

 

In addition toacquiring existing technology, we entered into non-compete and licensingagreements.  The non-compete agreementprohibits HSI from competing against us in all countries except Korea for fouryears from the valuation date. The licensing agreement requires that HSI pay us1% of revenue as royalty for the usage of the intellectual property that weacquired under the terms of the acquisition for fifteen years subsequent to thevaluation date.

 

*Audiovox Communications, Inc.*

 

### *On June 14, 2004, we announcedan agreement to acquire select assets of Audiovox Communications Corporation(“Audiovox”), the wireless handset division of Audiovox Corporation. We willacquire select assets and liabilities, including inventories, prepaids, third-partypayables, accrued expenses and the right to hire approximately 270 employeesfor $165.1 million in cash. We will acquire the Audiovox’s sales, service andsupport infrastructure, its CDMA handset brand, access to supply-chainchannels, product marketing expertise and key relationships with CDMA operatorsprimarily in North and South America. Closing of the transaction is subject tosatisfaction of certain conditions outlined in the purchase agreement.*

### * *

### ***Stockholders’ Equity***

 

On March 12, 2004, our Board ofDirectors approved a stock repurchase program, authorizing the repurchase of upto 5,000,000 shares of our outstanding common stock over a period of 6 months.The Board approved an additional repurchase of 1,623,000 shares in a privatelynegotiated transaction with an institution. As of June 30, 2004, we repurchased a total of approximately 3.6million shares under this program at an average price of $30.25 per share, fora total cash outflow of $107.6 million.

 

***Transactions with Softbank and AffiliatedEntities***

 

We recognized revenue of$21.1 million and $32.6 million for the three and six months endedJune 30, 2004, respectively, and revenue of $60.2 million and $118.7million for the three and six months ended June 30, 2003, respectivelywith respect to sales of telecommunications equipment to Softbank BBCorporation (“SBBC”), an affiliate of SOFTBANK CORP. and SOFTBANKAmerica Inc., a significant stockholder of ours. SBBC offers asynchronousdigital subscriber line (“ADSL”) coverage throughout Japan, which is marketedunder the name “YAHOO BB!”. The majority of the products we provide to SBBC isassociated with ADSL technology. The contract was competitively bid and theterms of this contract were on terms no more favorable than those with unrelatedparties. Included in accounts receivable at June 30, 2004 andDecember 31, 2003 were $29.9 million and $43.9 million, respectively,related to this agreement. There were insignificant amounts included indeferred revenue in respect to this agreement at June 30, 2004 and noamounts included in deferred revenue in respect to this agreement atDecember 31, 2003.

 

During 2000, we invested $10.0 million in Softbank China, aninvestment fund established by SOFTBANK CORP. focused on investments inInternet companies in China. This investment is intended to enable us toparticipate in the anticipated growth of Internet-related businesses in China.Our investment constitutes 10% of the funding for Softbank China, with SOFTBANKCORP. contributing the remaining 90%. The fund has a separate management team,and none of our employees are employed by the fund. Many of the fund’sinvestments are and will be in privately held companies, many of which arestill in the start-up or development stages. These investments are inherentlyrisky as the market for the technologies or products the companies have underdevelopment are typically in the early stages and may never materialize. Weaccount for this investment under the cost method and recorded no losses andinsignificant losses in the carrying value of this investment during the threeand six months ended June 30, 2004, respectively. We recordedinsignificant losses and losses of $0.1 million due to an other-than-temporarydecline in the carrying value of this investment during the three and sixmonths ended June 30, 2003, respectively. The balance in this investmentwas $5.3 million at June 30, 2004.

 

On July 17, 2003, we entered into aMezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”), an affiliate ofSOFTBANK America, Inc.  Under the termsof the agreement we loaned BB Modem $10.1 million at an effective interest rateof 12.01% per annum, for the purposes of investing in a portfolio of ADSLmodems and associated modem rental agreements, from SOFTBANK BB CORP., formerlyBB Technologies, an affiliate of SOFTBANK America, Inc.  SOFTBANK BB CORP. will continue to servicesuch modems and modem rental agreements. Our loan is subordinated to certain senior lenders of BB Modem, andrepayments are payable to us over a forty-two month period throughJanuary 31, 2007, with a substantial portion of the principal amount ofthe loan schedule to be repaid during the last 16 months of this period.  Our recourse for nonpayment of the loan islimited to the assets of BB Modem, the account into which subscriber paymentsare made and its rights under the securitization transaction documents.  The value of BB Modem’s modems that serve ascollateral for the loan may decrease over time and may not be sufficient uponsale to pay the outstanding amounts on the loans.  We assess the loan for impairment wheneverevents or changes in circumstances indicate that the carrying amount may not berecoverable.  We periodically review theunderlying quality of the asset pool securing the loan to assess whetherimpairment has incurred and needs to be recorded.  During three and six months endedJune 30, 2004, we recorded $.3 million and $.7 million, respectively, ininterest income in respect of this loan. The loan receivable at June 30, 2004 was approximately $11.2million and is included in other long-term assets.

 

During the first quarter of fiscal 2002, we invested $2.0 millionin Restructuring Fund No. 1, a venture capital investment limitedpartnership established by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANKCORP. The fund focuses on leveraged buyout investments in companies in Asiaundergoing restructuring or bankruptcy proceedings. The total fund offering isexpected to be between approximately $150.0 million and $226.0 million,with each investor contributing a minimum of $0.8 million. The fund has aseparate management team, and none of our employees are employed by the fund.We account for this investment under the equity method of accounting. Thebalance in this investment 

 

27

----

 

was $1.8 million at June 30, 2004.

 

On April 5, 2003, we repurchased 8.0 million shares of ourcommon stock beneficially owned by SOFTBANK America Inc., at a purchaseprice of $17.385 per share. The total cost of the repurchase was$139.6 million including transaction fees. In connection with thisrepurchase transaction, SOFTBANK America Inc. entered into an agreementwith us not to offer, sell or otherwise dispose of our common stock for aperiod of one year, subject to a number of exceptions. As of June 30,2004, SOFTBANK America Inc. beneficially owned approximately 12.9 % of ouroutstanding stock.

 

**RESULTS OF OPERATIONS**

 

Our net sales consist of product and service sales within three broadtelecommunications product lines: wireless infrastructure; wirelineinfrastructure and subscriber terminals including handsets and CPE.  Wireless infrastructure is primarilycomprised of the Personal Access System (“PAS”); iPAS; and CDMA products.  Wireline infrastructure is primarilycomprised of the AN2000, IPDSLAM, and other wireline products.  The subscriber terminal products include PAShandsets, CPE and will include CDMA handsets beginning in 2005.  During the second quarter of 2004, weexperienced 70% growth in net sales over the second quarter of 2003.  Net sales may not grow at the same rate ormay even decline in the future.  Withmany of our product sales, we provide installation services.  Additionally, we provide maintenance servicesfor some products.  In all periods, totalservices sales were less than 10% of net sales. 

 

Cost of sales consists primarily of material costs, payments to agents,costs associated with manufacturing, assembly and testing of products, costsassociated with installation and customer training and overhead and warrantycosts. Cost of sales also includes import taxes and tariffs on components andassemblies. Some components and materials used in our products are purchasedfrom a single supplier or a limited group of suppliers and, in some cases, aresubject to our obtaining Chinese import permits and approvals. We also rely onthird party manufacturers in China to manufacture and assemble the majority ofour products. 

 

Our gross profit has been affected by competitive pricing pressure, productmix and material costs. Our gross profit, as a percentage of net sales, variesamong our product families. We expect that our overall gross profit, as apercentage of net sales, will fluctuate from period to period as a result ofshifts in product mix, anticipated decreases in average selling prices fromcompetitive pricing pressure and our ability to reduce cost of sales.

 

Selling, general and administrative expenses include compensation andbenefits, professional fees, sales commissions, provision for doubtful accountsreceivable and travel and entertainment costs. A large percentage of our costsare fixed and are difficult to quickly reduce in periods of reduced sales. Weintend to pursue aggressive selling and marketing campaigns and to expand our directsales organization, and, as a result, our sales and marketing expenses willincrease in absolute dollars in future periods. We also expect that in supportof our continued growth, general and administrative expenses will continue toincrease in absolute dollars for the foreseeable future.

 

Research and development expenses consist primarily of salaries andrelated costs of employees engaged in research, design and developmentactivities, the cost of parts for prototypes, equipment depreciation and thirdparty development expenses. A large percentage of our costs is fixed anddifficult to quickly reduce in periods of reduced sales. Our research anddevelopment efforts are focused on developing both next-generation products aswell as working to upgrade our existing systems and products. We believe thatcontinued investment in research and development is critical to our long-termsuccess. Accordingly, we expect that our research and development expenses willincrease in absolute dollars in future periods.

 

Income tax expense is based upon a blended effective tax rate basedupon our expectation of the amount of income to be earned in each taxjurisdiction.  The primary drivers forincome tax expense includes both the total amount and location of the income earned.  The Company uses tax-planning strategies tominimize its income tax expense.  Incometax expense as a percentage of income before taxes will increase if relativelymore income is earned in higher tax environments.

 

28

----

 

**THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003**

 

**NET SALES**

 
| ** **                 | ** ** | **Three months ended June 30,** | ** **  | **Six months ended June 30,** | ** ** |
|----------------------------|------------|--------------------------------------|-------------|------------------------------------|------------|
| ** **                 | ** ** | **2004**                             | ** **  | ** **                         | ** ** | **2003** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **(in thousands)**                   | ** **  |
| **Sales by region**        |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| China                      |       | $                                    | 618,323     |                               | 90         | % | $ | 332,548 |   | 82 | % | $ | 1,188,889 |   | 91 | % | $ | 601,478 |   | 82 | % |
| Japan                      |       | 22,104                               |        | 3                                  | %          | 60,546 |   | 15 | % | 41,531 |   | 3 | % | 120,366 |   | 16 | % |
| Other                      |       | 49,201                               |        | 7                                  | %          | 12,740 |   | 3 | % | 81,499 |   | 6 | % | 14,510 |   | 2 | % |
| **TOTAL NET SALES**        |       | **$**                                | **689,628** |                               | 100        | % | **$** | **405,834** |   | 100 | % | **$** | **1,311,919** |   | 100 | % | **$** | **736,354** |   | 100 | % |
|                       |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Sales by product  line** |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Wireless infrastructure    |       | $                                    | 427,659     |                               | 62         | % | $ | 143,490 |   | 35 | % | $ | 764,176 |   | 58 | % | $ | 267,850 |   | 36 | % |
| Subscriber handsets        |       | 194,313                              |        | 28                                 | %          | 187,128 |   | 46 | % | 430,733 |   | 33 | % | 327,088 |   | 44 | % |
| Wireline products          |       | 67,656                               |        | 10                                 | %          | 75,216 |   | 19 | % | 117,010 |   | 9 | % | 141,416 |   | 20 | % |
| **TOTAL NET SALES**        |       | **$**                                | **689,628** |                               | 100        | % | **$** | **405,834** |   | 100 | % | **$** | **1,311,919** |   | 100 | % | **$** | **736,354** |   | 100 | % |

 

### *Threemonths ended June 30, 2004 and 2003*

 

In the second quarter of 2004, net sales increased by $283.8 million or70% over the second quarter of 2003. This increase was primarily driven by increases in wirelessinfrastructure sales of $284.2 million. The increase was attributable to increased demand from carriers in Chinaas a result of the increased number of subscribers.  Total PAS subscribers increased fromapproximately 20 million at June 30, 2003 to approximately 54 million atJune 30, 2004.  We believe that PASsubscriber growth will continue to grow to between 65 and 70 million subscribersby the end of 2004.  Wirelessinfrastructure revenues are directly affected by the timing of customeracceptance.  In the second quarter of2004, our customers accepted wireless infrastructure projects faster than wehave historically experienced.  This wasconsistent with our expectation of a quickening pace of the sales cycle for ourChina customers as they move from initial system implementation to systemexpansion.  

 

We group all of our China customers together by province and treat eachprovince as one customer since that is the level at which purchasing decisionsare made. At June 30, 2004 and 2003, we had 30 and 31 such customers,respectively. The Jiangsu and Hei Long Jiang provinces accounted for 15% and10% of our net sales, respectively, for the three months ended June 30,2004. The Hei Long Jiang, Zhejiang and Hebei provinces accounted for 13%, 11%and 10% of our net sales, respectively, for the three months endedJune 30, 2003. 

 

### *Sixmonths ended June 30, 2004 and 2003*

### * *

For the first six months of 2004, net sales increased by $575.6 millionor 78% over the first six months of 2003. This increase in sales was primarily attributable to increased demandfor our products and services resulting from an increased number ofsubscribers. Net sales growth was primarily due to an increase in subscribers,requiring telecommunication providers to expand their telecommunicationinfrastructures. Wireless infrastructure revenues are directly affected by thetiming of customer acceptance. In the first half of 2004,  our customers accepted wirelessinfrastructure expansion projects faster than we have historically experienced,increasing the percentage of net sales derived from wireless infrastructureproducts that were sold during the six months ended June 30, 2004 than inthe comparative period in 2003.

 

We group all of our China customers together by province and treat eachprovince as one customer since that is the level at which purchasing decisionsare made. At June 30, 2004 and 2003, we had 30 and 31 such customers,respectively. The Guangdong, Jiangsu and Hei Long Jiang provinces accounted for16%, 11% and 10% of our net sales, respectively, for the six months endedJune 30, 2004. The Hei Long Jiang province accounted for 13% of our netsales for the six months ended June 30, 2003. 

 

Thedecrease in wireline sales was attributable to several factors.  Sales of wireline products for the six monthsended June 30, 2004 were lower than the comparative period in the prioryear due to high levels of wireline product sales in the first half of 2003 dueto Japan’s expansion of its wireline infrastructure base in that period. 

 

29

----

 

Somewireline product shipments and customer acceptances were delayed until after thesecond quarter due to some supply chain difficulties, thereby reducing thewireline revenues recorded during the six months ended June 30, 2004.

 

Over the second six months of 2004, we expect wireless infrastructurerevenues to remain consistent with the first six months.  We expect our sales growth for the second sixmonths of 2004 to occur principally in our wireline products revenues andsecondly in our handset revenues.

 

**GROSS PROFIT**

 
| ** **              | ** ** | **Three months ended March 31,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **              | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **              | ** ** | **(in thousands)**                    | ** ** | **(in thousands)**                 | ** ** |
|                    |       |                                  |       |                               |       |   |   |   |   |
| Gross profit            |       | $                                     | 176,270    |                               | $          | 137,504 |   | $ | 352,305 |   | $ | 250,189 |   |
| Gross profit percentage |       | 26                                    | %          | 34                                 | %          | 27 | % | 34 | % |
|                         |            |                                       |            |                                    |            |  |  |  |  |  |  |  |  |

 

*Three months ended June 30, 2004 and2003*

 

Our gross profit varies across our different product lines and isaffected by product mix, average selling prices and the cost of materials.  We attribute the decrease in gross profit asa percent of net sales for the three months ended June 30, 2004 from thecorresponding period in 2003 mostly to declining margins on our handsetproducts. The declining margins resulted from increased competitive marketpricing pressures throughout the telecommunications market in the secondquarter of 2004. The declining margins on our handset products were slightlyoffset by the decreased percentage of handset sales, from 46% of net sales forthe second quarter of 2003 to 28% of net sales for the second quarter of 2004.Secondly, the decline in gross profit for the second quarter 2004 as comparedto the second quarter in 2003 was due to a smaller percentage of sales of ourhigher margin wireline products, from 19% of net sales during the secondquarter of 2003 to 10% of net sales for the same period in 2004.  In addition to having a lower percentage ofwireline sales this period, our margins decreased due to lower margins on aspecific contract upon which revenues were recognized in this period. Thisgross margin decline was offset by both higher margins and an increasedpercentage of our sales from iPAS/PAS systems. 

 

*Six months ended June 30, 2004 and 2003*

 

Our gross profit varies across our different product lines and isaffected by product mix, average selling prices and the cost of materials. Thedecrease in gross profit for the six months ended 2004 as compared to the sameperiod in 2003 was due to a smaller percentage of sales of our higher marginwireline products, from 20% of net sales for the six months ended June 30,2003 to 9% of net sales for the same period in 2004.  In addition to having a lower percentage ofwireline sales this period, our margins decreased due to lower margins on aspecific contract upon which revenues were recognized in this period.  We also attribute the decline in gross profitas a percent of net sales for the six months ended June 30, 2004 from thecorresponding period in 2003 to declining margins on our handset products.  The declining margins resulted from increasedcompetitive market pricing pressures throughout the telecommunications marketduring the first half of 2004. The declining margins on our handset productswere slightly offset by the decreased percentage of handset sales, from 44% ofnet sales for the six months ended June 30, 2003 to 33% of net sales forthe same period in 2004.  This grossmargin decline was offset by higher margins on our iPAS/PAS systems. Alsooffsetting declining gross margins was the increased percentage of our salesderived from iPAS/PAS systems, from 36% for the six months ended June 30,2003 to 58% for the six months ended June 30, 2004.

 

We believe that our overall gross profit as a percentage of net saleswill continue to fluctuate from period to period as a result of shifts inproduct mix, anticipated decreases in average selling prices as a result ofcompetition and our ability to reduce cost of sales. We expect that there willbe continued competitive market pricing pressures on our products in line withcurrent trends in the industry.  

 

30

----

 

**OPERATING EXPENSES**

 

The following table summarizes our operating expenses:

 
| ** **                                                   | ** ** | **Three months ended June 30,** | ** **  | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|-------------|------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                             | ** **  | **% of net  sales**                | ** ** | **2003** | ** ** | **% of net  sales** | ** ** | **2004** | ** ** | **% of net  sales** | ** ** | **2003** | ** ** | **% of net  sales** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                   | ** **  | **(in thousands)**                 | ** ** |
|                                                         |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative  (“SG&A”)  |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| expenses                                                     |       | $                                    | 67,830      |                               | 10         | % | $ | 34,963 |   | 9 | % | $ | 134,773 |   | 10 | % | $ | 72,546 |   | 10 | % |
| Research and development (“R&D”)               |       | 52,592                               |        | 8                                  | %          | 36,078 |   | 9 | % | 98,250 |   | 8 | % | 62,890 |   | 9 | % |
| In-process research and development  (“IPR&D”) |       | 1,400                                |        | 0                                  | %          | 9,328 |   | 2 | % | 1,400 |   | 0 | % | 10,648 |   | 1 | % |
| Amortization of intangible assets                            |       | 3,334                                |        | 0                                  | %          | 1,483 |   | 0 | % | 6,307 |   | 0 | % | 2,178 |   | 0 | % |
|                                                         |       |                                 |        |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **TOTAL OPERATING  EXPENSES**                                |       | **$**                                | **125,156** |                               | 18         | % | **$** | **81,852** |   | **20** | **%** | **$** | **240,730** |   | 18 | % | **$** | **148,262** |   | **20** | **%** |

 

*SELLING, GENERAL AND ADMINISTRATIVE*

 

The Company manages selling general and administrative expenses as apercentage of net sales.  In the currentquarter and six months, selling general and administrative expenses remainedconsistent with prior periods at approximately 10% of net sales.

 

*Three months ended June 30, 2004 and2003*

 

The increase of 94% in absolute dollars in selling, general andadministrative expenses was primarily due to the hiring of additional personnelto support our increased business activities both in China and globally.  Selling, general and administrative headcountincreased approximately 41% from an average of 2,088 employees for the threemonths ended June 30, 2003 to an average of 2,947 employees for the threemonths ended June 30, 2004. Secondly, bad debt expense is generally a function of the size of theaccounts receivable balance.  Grossaccounts receivable increased 100% over June 30, 2003, which resulted inan increase of approximately $10 million in bad debt expense between the secondquarter of 2004 compared to the second quarter of 2003.  Finally, the Company incurred additionalprofessional services fees related to Sarbanes-Oxley compliance and supplychain management, which resulted in an increase of approximately $7.0 millionfor professional services fees in the second quarter of 2004.

 

*Six months ended June 30, 2004 and 2003*

 

The increase of 86% in absolute dollars in selling, general andadministrative expenses was primarily due to the hiring of additional personnelto support our increased business activities both in China and globally.Selling, general and administrative headcount increased approximately 48% froman average of 1,895 employees for the six months ended June 30, 2003 to anaverage of 2,801 employees for the six months ended June 30, 2004.  Additionally, increases in professionalservices fees of $10.7 million and bad debt expense of $8.5 million for thefirst six months of 2004 compared to the first six months of 2003 contributedto the increase. 

 

*RESEARCH AND DEVELOPMENT*

 

The Company manages research and development expenses as a percentageof net sales.  In the current quarter andsix months, research and development expenses decreased compared with priorperiods.  The decrease of research anddevelopment expenses as a percentage of net sales was due to increasedeconomies of scale associated with increased business levels. The majority ofthe new personnel being hired in China, where labor costs are less expensivethan in the United States, also contributed to the decrease in research anddevelopment expenses as a percentage of net sales.

 

We expect research and development expense to remain constant as apercentage of net sales for the near future.

 

*Three months ended June 30, 2004 and 2003*

 

The 46% increase in absolute dollars of research and developmentexpenses was primarily due to hiring additional technical personnel to supportboth product enhancements and new product development. Research and developmentheadcount increased approximately 52% from an average of 1,787 employees forthe three months ended June 30, 2003 to an

 

31

----

 

average of 2,719 employees for the three months ended June 30,2004.  The significant majority of theincrease in research and development expenses from the three months endedJune 30, 2003 to the three months ended June 30, 2004 wasattributable to higher payroll and payroll-related costs resulting from ourcontinued expansion of our research and development teams in China, from a fullquarter’s salaries for CommWorks personnel as compared to one month’s salariesin the same period in the prior year and from additional employees hired inconjunction with the acquisitions of TELOS and HSI. 

 

*Six months ended June 30, 2004 and 2003*

 

The increase in absolute dollars of research and development expensesof 56% was primarily due to hiring additional technical personnel to supportboth product enhancements and new product development. Research and developmentheadcount increased approximately 57% from an average of 1,591 employees forthe six months ended June 30, 2003 to an average of 2,492 employees forthe six months ended June 30, 2004. The significant majority of theincrease in research and development expenses from the six months endedJune 30, 2003 to the six months ended June 30, 2004 was attributableto higher payroll and payroll-related costs resulting from our continuedexpansion of our research and development teams in China, from a full sixmonths of salaries for CommWorks personnel as compared to one month’s salariesin the same period in the prior year and from additional employees hired inconjunction with the acquisitions of TELOS and HSI.

 

*IN-PROCESS RESEARCH AND DEVELOPMENT*

 

*Three months ended June 30, 2004 and2003*

 

The $1.4 million charge to in-process research and development(“IPR&D”) for the three months ended June 30, 2004 was from ouracquisition of TELOS. Of the $9.3 million charge to IPR&D for the threemonths ended June 30, 2003, $1.3 million, $6.2 million and $1.9 millionwere due to the CommWorks, RollingStreams and Xebeo acquisitions,respectively.  All charges to IPR&Dwere based upon independent valuations.

 

*Six months ended June 30, 2004 and 2003*

 

The $1.4 million charge to IPR&D for the six months endedJune 30, 2004 was from our acquisition of TELOS. Of the $10.7 millioncharge to IPR&D for the six months ended June 30, 2003, $1.3 million,$6.2 million, $1.9 million and $1.3 million were due to the CommWorks,RollingStreams, Xebeo and Shanghai Yi Yun acquisitions, respectively. Allcharges to IPR&D were based upon independent valuations.

 

*AMORTIZATION OF INTANGIBLE ASSETS*

 

*Three months ended June 30, 2004 and2003*

 

The increase in the amortization of intangible assets for the threemonths ended June 30, 2004 was due to a full three months of amortizationexpense associated with the $44.9 million of intangibles recorded upon our May2003 CommWorks acquisition as compared to one month of expense for thecomparative period in the prior year. Additionally, the increase inamortization of intangible assets expense was due to additional amortizationexpenses related to $20.9 million and $5.2 million of intangible assetsrecorded upon our acquisitions of TELOS and HSI, respectively. The estimated usefullives of these purchased intangibles are from one to ten years.

 

### *Sixmonths ended June 30, 2004 and 2003*

 

The increase in the amortization of intangible assets for the sixmonths ended June 30, 2004 was due to a full six months of amortizationexpense associated with the $44.9 million of intangibles recorded upon our May2003 CommWorks acquisition as compared to one month of expense for thecomparative period in the prior year. Additionally, the increase inamortization of intangible assets expense was due to additional amortizationexpenses related to $20.9 million and $5.2 million of intangible assetsrecorded upon our acquisitions of TELOS and HSI, respectively. The estimateduseful lives of these purchased intangibles are from one to ten years.

 

We anticipate additional amortization expense will be incurred in thethird and fourth quarters of 2004 as the third quarter will include a fullthree months of amortization related to TELOS and HSI and the fourth quarterwill include

 

32

----

 

amortization expense related to the Audiovox transaction.

 

**OTHER INCOME (EXPENSES)**

 

*INTEREST INCOME*

 

*Three months ended June 30, 2004 and2003*

 

Interest income was $1.8 million and $0.7 million for the three monthsended June 30, 2004 and 2003, respectively. The increase in interestincome was due to higher average cash balances for the three months endedJune 30, 2004 as compared to the corresponding period in 2003.

 

*Six months ended June 30, 2004 and 2003*

 

Interest income was $3.2 million and $1.6 million for the six monthsended June 30, 2004 and 2003, respectively. The increase in interestincome was due to higher average cash balances for the six months endedJune 30, 2004 as compared to the corresponding period in 2003.

 

*INTEREST EXPENSE*

 

*Three months ended June 30, 2004 and2003*

 

Interest expense was $1.1 million and $2.2 million for the three monthsended June 30, 2004 and 2003, respectively.

 

*Six months ended June 30, 2004 and 2003*

 

Interest expense was $2.2 million and $2.8 million for the six monthsended June 30, 2004 and 2003, respectively. 

 

*OTHER INCOME (EXPENSE), NET*

 

*Three months ended June 30, 2004 and2003*

 

Net other income was $4.3 million and $0.2 million for the three monthsended June 30, 2004 and 2003, respectively. Net other income for the threemonths ended June 30, 2004 was primarily due to a $2.1 million tax refundreceived in China.  Additionally, we hada currency exchange gain of $0.9 million for the second quarter 2004 ascompared to a currency exchange loss of $2.3 million for the second quarter2003. We also earned a $0.5 million dividend from one of our investments duringthe three months ended June 2004. Net other income for the three monthsended June 30, 2003 was primarily due to a tax refund received in China of$2.6 million.

 

*Six months ended June 30, 2004 and 2003*

 

Net other income was $13.0 million and $4.3 million for the six monthsended June 30, 2004 and 2003, respectively. Net other income for the sixmonths ended June 30, 2004 was primarily due to our receiving a $7.8million financial subsidy from the local Chinese government during the firstquarter of 2004.  This subsidy was toencourage our investment in local research and development and manufacturingactivities.  We also recorded a currencyexchange gain of $0.5 million for the six months ended 2004 as compared to acurrency exchange loss of $1.5 million for the six months ended 2003.Additionally, we had a Japanese consumption tax refund of $1.4 million duringthe first quarter of 2004. Net other income for the six months endedJune 30, 2003 was primarily due to a $3.9 million reinvestment incentivepayment and a $2.6 million tax refund received in China.

 

33

----

 

### *EQUITYIN NET LOSS OF AFFILIATED COMPANIES*

 

*Three months ended June 30, 2004 and2003*

 

Equityin net loss of affiliated companies was $1.2 million and $1.7 million for thethree months ended June 30, 2004 and 2003, respectively, and primarilyresulted from losses incurred at our joint venture with MatsushitaCommunication Industrial Co., Ltd., and Matsushita Electric IndustrialCo., Ltd.

 

*Six months ended June 30, 2004 and 2003*

 

Equityin net loss of affiliated companies was $2.2 million and $2.7 million for thesix months ended June 30, 2004 and 2003, respectively, and primarilyresulted from losses incurred at our joint venture with MatsushitaCommunication Industrial Co., Ltd., and Matsushita Electric IndustrialCo., Ltd.

 

### *INCOMETAX EXPENSE*

### * *

*Three months ended June 30, 2004 and2003*

 

Income tax expense was $11.0 million and $13.1 million for the threemonths ended June 30, 2004 and 2003, respectively. The primary reason forthe decrease in income tax expense was due to our overall effective tax ratedecreasing to 20% for 2004 from 25% in 2003. This decrease was a result of continued tax holidays in China as well asa greater proportion of income in countries with low tax rates.  We expect that our income tax expense willgrow in absolute dollars in line with anticipated increases in pretax income.

 

*Six months ended June 30, 2004 and 2003*

 

Income tax expense was $24.7 million and $25.6 million for the sixmonths ended June 30, 2004 and 2003, respectively. The primary reason forthe decrease in income tax expense despite the fact that our income beforetaxes increased 20% for the six months ended June 30, 2004 from thecorresponding period in 2003 was that the overall effective tax rate for 2004decreased to 20% from 25% in 2003.  This decreasewas a result of continued tax holidays in China as well as a greater proportionof income in countries with low tax rates. We expect that our income tax expense will grow in absolute dollars inline with anticipated increases in pretax income.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

*Operating Activities*

 

*2004*

 

Net cash used in operating activities for the six months endedJune 30, 2004 was $118.5 million. Operating cash was affected by changesin customer advances, inventory and accounts receivable offset by net incomeand non-cash charges including depreciation and amortization and changes indeferred costs and accounts payable.  

 

The $179.1 million increase in accounts receivable was attributable toa larger volume of sales, from $736.4 million for the six months endedJune 30, 2003 to $1.3 billion for the same period in 2004. Alsocontributing to a larger accounts receivable balance was that we had longercollection periods during the six months ended June 30, 2004 as comparedto the same period in the prior year; our days sales outstanding was 70 days atJune 30, 2004 as compared to 58 days at June 30, 2003.   We project that our days sales outstandingwill fluctuate between 60 and 80 days for the remainder of 2004.

 

Inventory, net of inventory provision, increased by $193.0 million,also decreasing our operating cash.  Aswe expect sales to increase in subsequent quarters, we continued to build ourinventory supply in this period to meet the anticipated demand in futureperiods.  

 

The $309.8 million decrease in customer advances also decreased operatingcash for the period.  Customer advances,which represent cash deposits we have received from our customers for ordersthat have not yet received final acceptance, decreased due to an increasedamount of customer acceptances.  As ourcustomers in China transition from new system installations to systemexpansions, we believe that the period between customer advance and acceptancewill shorten which will result in smaller customer advance balances for thosecustomers. 

 

34

----

 

Offsetting the activity that decreased operating cash for the periodwere net income and non-cash charges including depreciation and amortizationand changes in deferred costs and accounts payable. Net income was $98.6million, adjusted for non-cash charges including $34.0 million of depreciationand amortization.  Deferred costs, orinventory at customer sites awaiting final acceptance, decreased by $223.3million.  The decrease in deferred costswas also a result of increased revenues and a greater number of customeracceptances, corresponding to the decrease in customer advances.  Accounts payable increased by $136.9 million,consistent with increased inventory purchasing.

 

*2003*

 

Net cash used in operations for the six months ended June 30, 2003of $155.9 million was primarily due to an increase in inventory, deferredcosts, accounts receivable and other current and non-current assets of $254.1million, $405.9 million, $42.3 million and $121.0 million, respectively.  This was partially offset by net income of$76.8 million, adjusted for non-cash charges including depreciation andamortization expense of $17.7 million and in-process research and developmentcosts of $10.6 million, as well as growth in deferred revenue of $362.2 million,accounts payable of $165.6 million, other current liabilities of $26.5 millionand customer advances of $9.2 million.

 

*Investing Activities*

 

*2004*

 

Net cash used in investing activities for the six months endedJune 30, 2004 of $155.7 million was primarily due to purchases ofproperty, plant and equipment to support our expansion.  Of the total $62.5 million invested inproperty, plant and equipment, construction costs incurred on our Hangzhoumanufacturing facility were $35.1 million during the period.  The Company anticipates a total investmentfor the Hangzhou facility of $138 million of which an additional $31 million isexpected to be incurred.    Alsocontributing to net cash used in investing activities was our purchases ofTELOS and HSI, which resulted in a cash outflow of $44.7 million.   The Company anticipates that the Audiovoxtransaction will close early in the fourth quarter of 2004 and will require acash payment of $165.1 million at that time.  Finally, net purchases of short-term investments of $35.3 millioncontributed to cash used in investment activities.

 

*2003*

 

Net cash used in investing activities for the six months endedJune 30, 2003 of $42.8 million was primarily due to business acquisitionsof $109.5 million and purchases of property, plant and equipment of $41.2million, offset by net sales of short-term investments of $113.0 million. 

 

*Financing Activities*

 

*2004*

 

Net cash provided by financing activities was $384.7 million for thesix months ended June 30, 2004. This was primarily due to proceeds raised from our selling 12.1 millionshares of common stock at $39.25 per share to Banc of America Securities, LLC,for net proceeds of approximately $474.6 million. In addition to the sale ofstock, we received $17.7 million for the issuance of common stock through stockoption and warrant exercises. Offsetting cash provided by financing activities,we used a portion of the capital raised to repurchase a total of 3.6 millionshares of our common stock at an average price of $30.25 per share for a totalcost of $107.6 million, including transaction fees.

 

*2003*

 

Net cash provided by financing activities for the six months endedJune 30, 2003 of $243.0 million was primarily due to the offering ofconvertible subordinated notes of $391.4 million and proceeds from the exerciseof stock options of $35.0 million, offset by the repurchase of shares fromSoftbank of $139.6 million and purchases of call options for $43.8 million.

 

*Liquidity*

 

Our working capital was $1.3 billion and $779.6 million at June 30,2004 and 2003, respectively. This increase in working capital is due toincreased cash on hand, to $484.8 million in cash and cash equivalents and$77.0 of short-term investments at June 30, 2004, from $276.0 million ofcash and cash equivalents and $5.3 million of short-term investments atJune 30, 2003. Our working capital also increased due to larger accountsreceivable and inventory balances and lower customer advances, offset bysmaller deferred costs balances, and higher accounts payable and deferredrevenue balances. Cash on hand increased due to remaining proceeds from $474.6million of net proceeds received from our equity offering in January 2004.We believe that this cash

 

35

----

 

 positions us to take advantageof strategic investment opportunities.

 

Our China sales are generally denominated in local currency. Due to thelimitations on converting Renminbi, we are limited in our ability to engage inforeign currency hedging activities in China. Sales outside China are generallydenominated in US dollars. We cannot guarantee that fluctuations in foreigncurrency exchange rates in the future will not have a material adverse effecton revenues from international sales and, correspondingly, on our business,financial condition and results of operations. We have contracts negotiated inJapanese Yen and we maintain a bank account in Japanese Yen for purchasingportions of our inventories and supplies. The balance of this Japanese Yenaccount at June 30, 2004 was approximately $36.7 million. Beginningin the first quarter of 2004, we hedge certain Japanese Yen-denominated balancesheet exposures against future movements in foreign currency exchange rates byusing foreign currency forward contracts. Gains and losses on these fair valuehedges are intended to offset gains and losses from the revaluation of ourJapanese Yen-denominated recognized liabilities. In accordance with Statementof Financial Accounting Standards No. 133 (“SFAS 133”), “Accounting for DerivativeInstruments and Hedging Activities,” we recognize derivative instruments andhedging activities as either assets or liabilities on the balance sheet andmeasure them at fair value. The net result of gains and losses on contracts andrevaluation included in interest and other income (expense) was insignificantfor the three and six months ended June 30, 2004. Our foreign currencyforward contracts generally mature within three months. We do not intend toutilize derivative financial instruments for trading purposes. There were noforeign currency forward contracts held at June 30, 2004.

 

We believe that our existing cash and cash equivalents, short-terminvestments and cash from operations will be sufficient to finance ouroperations through at least the next 12 months. As of June 30, 2004,we had cash, restricted cash, short-term investments and restricted short-terminvestments of $604.4 million and lines of credit totaling $566.8 millionavailable for future borrowings. $264.8 million of these facilities expire in2004 and $302.0 million of these facilities expire between 2005 and 2010.   Of our total cash balance, $174.0 million isheld in China where currency exchange controls exist.  As a result, our ability to make payments inother jurisdictions could be limited by our ability to move money from China tothe other jurisdictions.  

 

In the event that our current cash balances, future cash flows fromoperations and current lines of credit are not sufficient to meet ourobligations or strategic needs or in the event that market conditions arefavorable, we would consider raising additional funds in the capital or equitymarkets. If additional financing is needed, there can be no assurance that suchfinancing will be available to us on commercially reasonable terms, or at all.

 

*Income taxes*

 

Our subsidiaries and joint ventures located in China enjoy tax benefitswhich are generally available to foreign investment enterprises, including fullexemption from national enterprise income tax for two years starting from thefirst profit making year and a 50% reduction in national income tax rate forthe following three years. In addition, local enterprise income tax is oftenwaived or reduced during this tax holiday/incentive period. Under currentregulations in China, foreign investment enterprises that have been accreditedas advanced and high-tech enterprises are entitled to additional taxincentives. These tax incentives vary in different locales and could includepreferential national enterprise income tax treatment at 50% of the usual ratesfor different periods of time. The tax holidays discussed above are applicableto UTStarcom (Chongqing) Co., Ltd. (“CUTS”), UTStarcom Telecom Co., Ltd.(“HUTS”), Hangzhou UTStarcom Telecom Co., Ltd. (“HSTC”) and UTStarcom ChinaCo., Ltd. (“UTSC”), our active subsidiaries in China, as those entities qualifyas accredited advanced and high-tech enterprises. Specifically, HUTS currentlyenjoys a 15% tax rate that will continue indefinitely provided they continue toqualify their status as an advanced and high-tech enterprise and the Governmentdoes not change the tax laws. UTSC currently enjoys a 10% holiday tax rate thatexpires on December 31, 2005, at which point they will be subject to a 15%tax rate provided they continue to qualify as an advanced and high-techenterprise and the Government does not change the tax laws. HSTC and CUTS arecurrently exempt from income tax until December 31, 2004, at which pointthey will be subject to a 7.5% tax rate, which will expire on December 31,2007.

 

We are working to implement a research and development cost sharingarrangement among our key worldwide entities. The purpose of cost sharing is to enable its participants to jointlydevelop and own intangibles.  Underresearch and development cost sharing, the total research and developmentexpense is paid by cost-sharing participants in proportion to eachparticipant’s future sales.  The benefitis that there is greater certainty with respect to transfer pricing and definedownership of IP. Cost sharing in China is a new concept and we are workingclosely with the China Tax and Regulatory Authorities to gain approval for costsharing.

 

36

----

 

*Contractual obligations and other commitments*

 

Our obligations under contractual obligations andcommercial commitments are primarily with regard to leasing arrangements andstandby letters of credit and are as follows:

 
| ** **                      | ** ** | **June 30, 2004  Payments Due by Period** | ** ** |
|---------------------------------|------------|------------------------------------------------|------------|
| **(in  thousands)**             | ** ** | **Total**                                      | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** |
| *Contractual  Obligations*      |       |                                           |       |   |   |   |   |   |   |
| Notes Payable                   |       | $                                              | 1,500      |   | $ | 1,500 |   | $ | — |   | $ | — |   |
| Convertible Subordinated Notes  |       | $                                              | 402,500    |   | $ | — |   | $ | — |   | $ | 402,500 |   |
| Operating leases                |       | $                                              | 24,885     |   | $ | 11,322 |   | $ | 13,145 |   | $ | 418 |   |
| *Other Commercial  Commitments* |       |                                           |       |   |   |   |   |   |   |
| Standby letters of credit       |       | $                                              | 35,874     |   | $ | 35,874 |   | $ | — |   | $ | — |   |
| Purchase commitments            |       | $                                              | 39,600     |   | $ | 39,600 |   |   |   |   |   |

 

### *Notespayable*

 

Occasionally, the Company issues short-term notes payable to itsvendors in lieu of trade accounts payable. The payment terms are normally three to six months and are typicallynon-interest bearing.  

 

### *Convertiblesubordinated notes*

 

Our $402.5 million of convertible subordinated notes, dueMarch 1, 2008, bear interest at a rate of 7/8% per annum, payable semiannually onMay 1 and September 1, are convertible into the Company’s commonstock at a conversion price of $23.79 per share and are subordinated to allpresent and future senior debt of the Company. The principal is due only atmaturity of the notes.

 

### *Operatingleases*

 

We lease certain facilities undernon-cancelable operating leases that expire at various dates through 2008. 

 

*Audiovox purchase price payable*

 

### *Upon the closing of the Audiovoxpurchase transaction, which is anticipated during the fourth quarter of 2004,we will be required to pay approximately $165.1 million in cash. The closing ofthe transaction is subject to satisfaction of certain conditions outlined inthe purchase agreement.*

### * *

### *Standbyletters of credit*

 

We issue standby letters of credit primarily to support internationalsales activities outside of China. When we submit a bid for a sale, often thepotential customer will require that we issue a bid bond or a standby letter ofcredit to demonstrate our commitment through the bid process. In addition, wemay be required to issue standby letters of credit as guarantees for advancecustomer payments upon contract signing or performance guarantees. The standbyletters of credit usually expire six to nine months from date of issuance withoutbeing drawn by the beneficiary thereof.

 

*Purchase commitments*

 

We are obligated to purchase raw materials and work-in-processinventory under various orders from three suppliers, all of which should befulfilled without adverse consequences material to our operations or financialcondition. As of June 30, 2004, total open commitments under thesepurchase orders were approximately $39.6 million.

 

*Joint venture funding*

 

Pursuant to the joint ventureagreement with Matsushita, we are jointly liable for the losses incurred in theoperations of the joint venture up to the maximum of our investment in theentity.  At June 30, 2004, thelosses had exceeded this amount; however, we had accrued additional losses of approximately$1.2 million during the three months ended June

 

37

----

 

30, 2004 due to our commitment to fund an additional investment of $9.3million. We have cumulative losses of $2.2 million recorded within othercurrent liabilities.

 

*Investment commitments*

 

As of June 30, 2004, we had invested a total of $2.0 millionin Global Asia Partners L.P. that is recorded as a long-term investment. Thefund size is anticipated to be $10.1 million and the fund was formed tomake private equity investments in private or pre-IPO technology andtelecommunications companies in Asia. We have a commitment to invest up to amaximum of $5.0 million. The remaining amount is due at such times and insuch amounts as shall be specified in one or more future capital calls to be issuedby the general partner.

 

### *Intellectualproperty*

### * *

Certain sales contracts include provisions under which customers wouldbe indemnified by us in the event of, among other things, a third-party claimagainst the customer for intellectual property rights infringement related toour products. There are no limitations on the maximum potential future paymentsunder these guarantees. We have not accrued any amounts in relation to theseprovisions as no such claims have been made and we believe we have validenforceable rights to the intellectual property embedded in our products.

 

*Accounts receivable transferred to notesreceivable*

 

We accept commercial notes receivable with maturity dates between threeand six months from our customers in China in the normal course of business. Wemay discount these notes with banking institutions in China. Notes receivableavailable for sale were $42.9 million and $11.4 million at June 30,2004 and December 31, 2003, respectively. A sale of these notes is reflectedas a reduction of notes receivable and the proceeds of the settlement of thesenotes are included in cash flows from operating activities in the consolidatedstatement of cash flows. There were no notes receivable sold during the threeand six months ended June 30, 2004; there were $25.3 million and $44.5million of notes receivable sold during the three and six months endedJune 30, 2003, respectively.  Thesenotes are not included in our consolidated balance sheets as the criteria forsale treatment established by SFAS 140, has been met. The costs of settling ortransferring these notes receivable were $0.3 million and $0.5 million for thethree and six months ended June 30, 2003, and were included in otherincome, net in the Consolidated Statements of Operations. 

 

**RECENT ACCOUNTING PRONOUNCEMENTS**

 

In November 2003,the EITF issued EITF No. 03-6 “Participating Securities and the Two-ClassMethod under FASB Statement No. 128,” which provides for a two-class method ofcalculating earnings per share computations that relate to certain securitiesthat would be considered to be participating in conjunction with certain commonstock rights. This guidance was applicable to the Company starting with thesecond quarter beginning April 1, 2004. We have evaluated the impact ofthis pronouncement and determined that there was no effect on our financialstatements.

 

On April 9, 2004, the FASB issued FASB Staff Position (“FSP”) to SFAS 129-1, Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities to provide disclosure guidance for contingently convertible securities, including those instruments with contingent conversion requirements that have not been met and otherwise are not required to be included in the computation of diluted earnings per share. The FSP addresses concerns that disclosures relating to contingently convertible securities are inconsistent between companies or may be inadequate. FSP SFAS 129-1 notes that to comply with the requirements of SFAS 129, the significant terms of the conversion features of the contingently convertible security should be disclosed to enable users of financial statements to understand the circumstances of the contingency and the potential impact of conversion. We have evaluated the impact of this pronouncement and have enhanced our disclosures as required.  For additional information about our outstanding convertible securities, please refer to Note 14 of our Condensed Consolidated Financial Statements, Debt.

 

38

----

 

**FACTORS AFFECTING FUTURE OPERATING RESULTS**

 

**RISKS RELATED TO OUR COMPANY**

 

***Ourfuture product sales are unpredictable and, as a result, our operating resultsare likely to fluctuate from quarter to quarter.***

 

Our quarterly and annual operating results have fluctuated in the pastand are likely to fluctuate in the future due to a variety of factors, some ofwhich are outside of our control. Factors that may affect our future operatingresults, in addition to those described below, include:

 

•                                          thetiming and size of the orders for our products;

 

•                                          changesin our customers’ subscriber growth rate;

 

•                                          thelengthy and unpredictable sales cycles associated with sales of our products;

 

•                                          cancellation,deferment or delay in implementation of large contracts;

 

•                                          ourrevenue recognition, which is based on acceptance, is unpredictable;

 

•                                          aseasonal reoccurrence of an outbreak of severe acute respiratory syndrome(SARS) or other illnesses affecting areas in which we operate;

 

•                                          thedecline in business activity we typically experience during the Chinese LunarNew Year holiday, which leads to decreased sales during our first fiscalquarter relative to historical and expected year-long trends; and

 

•                                          changesin accounting rules, such as recording expenses related to employee stockoption compensation plans.

 

As a result of these and other factors, period-to-period comparisons ofour operating results are not necessarily meaningful or indicative of futureperformance. Furthermore, it is possible that in some future quarters ouroperating results will fall below the expectations of securities analysts orinvestors. If this occurs, the trading price of our common stock could decline.

 

***Competitionin our markets may lead to reduced prices, revenues and market share.***

 

We believe that we will continue to face intense competition from bothdomestic and international companies in our target markets, many of which mayoperate under lower cost structures or may be given preferential treatment byapplicable governmental regulators and policies and have much larger salesforces than we do. Additionally, other companies not presently offeringcompeting products may also enter our target markets. Many of our competitorshave significantly greater financial, technical, product development, sales,marketing and other resources than we do. As a result, our competitors may beable to respond more quickly to new or emerging technologies and changes inservice provider requirements. Our competitors may also be able to devotegreater resources than we can to the development, promotion and sale of newproducts. These competitors may be able to offer significant financingarrangements to service providers, which may give them a competitive advantagein selling systems to service providers with limited financial and currencyresources. In many of the developing markets in which we operate or intend tooperate, relationships with local governmental telecommunications agencies areimportant to establish and maintain. In many such markets, our competitors mayhave or be able to establish better relationships with local governmentaltelecommunications agencies than we have, which could result in their abilityto influence governmental policy formation and interpretation to theiradvantage. Additionally, our competitors might have better relationships withtheir third-party suppliers and obtain component parts at a reduced rate,allowing them to offer their end products at reduced prices. Increasedcompetition is likely to result in price reductions, reduced gross profit as apercentage of net sales and loss of market share, any one of which couldmaterially harm our business, financial condition, cash flows, and results ofoperations.

 

***The average sellingprices of our products may decrease, which may reduce our revenues and ourgross profit. As a result, we must introduce new products and reduce our costsin order to maintain profitability.***

 

The average selling prices for communications access and switchingsystems and handsets have historically declined as a result of a number offactors, including:

 

39

----

 

•                                          increasedcompetition;

 

•                                          aggressiveprice reductions by competitors; and

 

•                                          rapidtechnological change.

 

The average selling prices of our products may continue to decrease inthe future in response to product introductions by us or our competitors orother factors, including price pressures from customers. Therefore, we mustcontinue to develop and introduce new products and enhancements to existingproducts that incorporate features that can be sold at higher average sellingprices. Failure to do so could cause our revenues and gross profit to decline.

 

Our cost reduction efforts may not allow us to keep pace withcompetitive pricing pressures or lead to improved gross profit, as a percentageof net sales. In order to be competitive, we must continually reduce the costof manufacturing our products through design and engineering changes. We may notbe successful in these efforts or in delivering our products to market in atimely manner. In addition, any redesign may not result in sufficient costreductions to allow us to reduce the prices of our products to remaincompetitive or to improve or maintain our gross profit, as a percentage of netsales, which would cause our financial results to suffer.

 

***Sales in China haveaccounted for most of our total sales, and our business, financial conditionand results of operations are to a significant degree subject to economic,political and social events in China.***

 

Approximately $618.3 million, or 90%, and $1.2 billion, or 91%, of ournet sales for the three and six months ended June 30, 2004, respectively,occurred in China. Approximately $332.5 million, or 82%, and $601.5 million, or82%, of our net sales for the three and six months ended June 30, 2003,respectively, occurred in China. While we anticipate expansion into otherforeign markets, a significant majority of our net sales will be derived from Chinafor the foreseeable future. In addition, we plan to continue to make furtherinvestments in China in the future. Therefore, our business, financialcondition and results of operations are to a significant degree subject toeconomic, political, legal and social developments and other events in China.Please read the risks detailed below under the heading “Risks Related toConducting Business in China” for additional information about the risks weface in connection with our China operations.

 

***Our market issubject to rapid technological change, and to compete effectively, we mustcontinually introduce new products and product enhancements that achieve marketacceptance.***

 

The market for communications equipment is characterized by rapidtechnological developments, frequent new product introductions and evolvingindustry and regulatory standards. Our success will depend in large part on ourability to enhance our network and broadband access and switching technologiesand develop and introduce new products and product enhancements that anticipatechanging service provider requirements and technological developments. We mayneed to make substantial capital expenditures and incur significant researchand development costs to develop and introduce new products and enhancements.If we fail to develop and introduce new products or enhancements to existingproducts that effectively respond to technological change on a timely basis,our business, financial condition and results of operations could be materiallyadversely affected. Moreover, from time to time, our competitors or we mayannounce new products or product enhancements, technologies or services thathave the potential to replace or shorten the life cycles of our products andthat may cause customers to defer purchasing our existing products, resultingin inventory obsolescence. Future technological advances in the communicationsindustry may diminish or inhibit market acceptance of our existing or futureproducts or render our products obsolete.

 

Even if we are able to develop and introduce new products, they may notgain market acceptance. Market acceptance of our products will depend onvarious factors, including:

 

•                                          ourability to obtain necessary approvals from regulatory organizations within thecountries in which we operate and for any new technologies that we introduce;

 

•                                          thelength of time it takes service providers to evaluate our products, causing thetiming of purchases to be unpredictable;

 

•                                          ourproducts being compatible with legacy technologies and standards existing inpreviously deployed network equipment;

 

40

----

 

•                                          ourability to attract customers who may have preexisting relationships with ourcompetitors;

 

•                                          productcost relative to performance; and

 

•                                          thelevel of customer service available to support new products.

 

If our products fail to obtain marketacceptance in a timely manner, our business could suffer.

 

***We depend on somesole source and other key suppliers, as well as international sources, forhandsets, base stations, components and materials used in our products. If wecannot obtain adequate supplies of high quality products at competitive pricesor in a timely manner from these suppliers or sources, our competitiveposition, reputation and business could be harmed.***

 

We have contracts with a single supplier or with a limited group ofsuppliers to purchase some components and materials used in our products. Ifany supplier is unwilling or unable to provide us with high-quality components andmaterials in the quantities required and at the costs specified by us, we maynot be able to find alternative sources on favorable terms, in a timely manner,or at all. Our inability to obtain or to develop alternative sources if and asrequired could result in delays or reductions in manufacturing or productshipments. From time to time, there could be shortages of different componentsor materials used in our products. For example, in 2001 and 2002 there was aworldwide shortage of handset components resulting from our third-partymanufacturers’ inability to assemble and manufacture a sufficient quantity ofhandsets to keep pace with consumer demand. Moreover, our suppliers may supplyus with inferior quality products. If an inferior product supplied by a thirdparty is embedded in our end product and causes a problem, it might bedifficult to identify the source of the problem as being due to the componentparts. If any of these events occur, our competitive position, reputation andbusiness could suffer.

 

Our ability to source a sufficient quantity of high-quality,cost-effective components used in our products may also be limited by importrestrictions and duties in the foreign countries in which we manufacture ourproducts. We require a significant number of imported components to manufactureour products, and imported electronic components and other imported goods usedin the operation of our business may be limited by a variety of permitrequirements, approval procedures, import duties and registration requirements.Moreover, import duties on such components increase the cost of our productsand may make them less competitive.

 

***If we seek to secureadditional financing and are not able to do so, our ability to expandstrategically may be limited. If we are able to secure additional financing,our stockholders may experience dilution of their ownership interest, or we maybe subject to limitations on our operations and increased leverage.***

 

We currently anticipate that our available cash resources, whichinclude existing cash and cash equivalents, short-term investments and cashfrom operations, will be sufficient to meet our anticipated needs for workingcapital and capital expenditures for the foreseeable future. If we are unableto generate sufficient cash flows from operations, we may need to raiseadditional funds to develop new or enhanced products, respond to competitivepressures, take advantage of acquisition opportunities or raise capital forstrategic purposes. If we raise additional funds through the issuance of equitysecurities, our stockholders will experience dilution of their ownershipinterest, and the newly issued securities may have rights superior to those ofcommon stock. If we raise additional funds by issuing debt, we may be subjectto limitations on our operations and increase our leverage. For example, inconnection with the sale of convertible debt securities in March 2003, weincurred $402.5 million of indebtedness. As a result of this indebtedness,our principal and interest payment obligations have increased substantially.The degree to which we are leveraged could materially and adversely affect ourability to obtain financing for working capital, acquisitions or other purposesand could make us more vulnerable to industry downturns and competitivepressures. Our ability to meet our debt service obligations will be dependentupon our future performance, which will be subject to financial, business andother factors affecting our operations, many of which are beyond our control. Finally,additional sources of financing may not be available on reasonable terms or atall if and when we require it, which could harm our business.

 

***Our recent growthhas strained our resources, and if we are unable to manage and sustain ourgrowth, our operating results will be negatively affected.***

 

We have recently experienced a period of rapid growth and anticipatethat we must continue to expand our operations to address potential marketopportunities. Our expansion has placed and will continue to place asignificant strain on our management, operational, financial and otherresources. To manage our growth effectively, we will need to take variousactions, including:

 

41

----

 

•                                          enhancingmanagement information systems and forecasting procedures;

 

•                                          furtherdeveloping our operating, administrative, financial and accounting systems andcontrols;

 

•                                          managingour working capital and sources of financing to fund our expansion;

 

•                                          maintainingclose coordination among our engineering, accounting, finance, marketing, salesand operations organizations;

 

•                                          expanding,training and managing our employee base;

 

•                                          improvingand sustaining our supply chain capability;

 

•                                          managingthe expansion of both our direct and indirect sales channels in acost-efficient and competitive manner; and

 

•                                          fullyreview our new customers’ credit histories and ensure their financial stabilitybefore finalizing contracts.

 

If we fail to implement or improve systems or controls or to manage anyfuture growth and expansion effectively, our business could suffer.

 

***Our success isdependent on continuing to hire and retain qualified personnel, and if we arenot successful in attracting and retaining these personnel, our business willsuffer.***

 

The success of our business depends in significant part upon thecontinued contributions of key technical and senior management personnel, manyof whom would be difficult to replace. In particular, our success depends inlarge part on the knowledge, expertise and services of Hong Liang Lu, ourChairman of the Board, President and Chief Executive Officer, and Ying Wu, ourChairman and Chief Executive Officer of China Operations. The loss of any keyemployee, the failure of any key employee to perform satisfactorily in his orher current position or our failure to attract and retain other key technicaland senior management employees could have a significant negative impact on ouroperations.

 

To effectively manage our recent growth as well as any future growth,we will need to recruit, train, assimilate, motivate and retain qualifiedemployees both locally and internationally. Competition for qualified employeesis intense, and the process of recruiting personnel with the combination ofskills and attributes required to execute our business strategy can bedifficult, time-consuming and expensive. As we grow globally, we must implementhiring and training processes that are capable of quickly deploying qualifiedlocal residents to knowledgeably support our products and services.Alternatively, if there is an insufficient number of qualified local residentsavailable, we might incur substantial costs importing expatriates to servicenew global markets. For example, we have historically experienced difficultyfinding qualified accounting personnel knowledgeable in both U.S. and Chineseaccounting standards who are Chinese residents. If we fail to attract, hire,assimilate or retain qualified personnel, our business would be harmed.

 

Competitors and others have in the past, and may in the future, attemptto recruit our employees. In addition, companies in the telecommunicationsindustry whose employees accept positions with competitors frequently claimthat the competitors have engaged in unfair hiring practices. We may be thesubject of these types of claims in the future as we seek to hire qualifiedpersonnel. Some of these claims may result in material litigation anddisruption to our operations. We could incur substantial costs in defendingourselves against these claims, regardless of their merit.

 

***Any acquisitionsthat we undertake could be difficult to integrate, disrupt our business, diluteour stockholders and harm our operating results.***

 

We have acquired other businesses, products and technologies. For  example, during the second quarter, wecompleted our acquisitions of TELOS and HSI for $30.3 million and $14.1million.  Additionally, in June, 2004, weannounced our acquisition of certain assets of Audiovox for $165.1 million, anacquisition that we expect to close in the fourth quarter of 2004.  Any anticipated benefits of theseacquisitions may not be realized. We have in the past and will continue toevaluate acquisition prospects that would complement our existing product offerings,augment our market coverage, enhance our technological capabilities, or thatmay otherwise offer growth opportunities. Acquisitions may result in dilutiveissuances of equity securities, use of our cash resources, the incurrence ofdebt and the amortization of expenses related to intangible assets. Inaddition,

 

42

----

 

acquisitions involve numerous risks, including difficulties in theassimilation of operations, technologies, products and personnel of theacquired company, diversion of management’s attention from other businessconcerns, risks of entering markets in which we have no direct or limited priorexperience, the potential loss of key employees of the acquired company,unanticipated costs and, in the case of the acquisition of financially troubledbusinesses, challenges as to the validity of such acquisitions from third partycreditors of such businesses.

 

***We may be unable toadequately protect the loss or misappropriation of our intellectual property,which could substantially harm our business.***

 

We rely on a combination of patents, copyrights, trademarks, tradesecret laws and contractual obligations to protect our technology. We haveapplied for patents in the United States and internationally. Additionalpatents may not be issued from our pending patent applications, and our issuedpatents may not be upheld. In addition, we have, from time to time, chosen toabandon previously filed applications. Moreover, we may face difficulties inregistering our existing trademarks in new jurisdictions in which we operate.We cannot guarantee that the intellectual property protection measures that wehave taken will be sufficient to prevent misappropriation of our technology ortrademarks or that our competitors will not independently develop technologiesthat are substantially equivalent or superior to ours. In addition, the legalsystems of many foreign countries do not protect or honor intellectual propertyrights to the same extent as the legal system of the United States. Forexample, in China, the legal system in general, and the intellectual propertyregime in particular, are still in the development stage. It may be verydifficult, time-consuming and costly for us to attempt to enforce ourintellectual property rights in these jurisdictions.

 

***We may be subject toclaims that we infringe the intellectual property rights of others, which couldsubstantially harm our business.***

 

The industry in which we compete is moving towards aggressiveassertion, licensing, and litigation of patents and other intellectual propertyrights. From time to time, we have become aware of the possibility or have beennotified that we may be infringing certain patents or other intellectualproperty rights of others. Regardless of their merit, responding to such claimscould be time consuming, divert management’s attention and resources and causeus to incur significant expenses. In addition, although some of our suppliercontracts provide for indemnification from the supplier with respect to lossesor expenses incurred in connection with any infringement claim, some of ourcontracts do not provide for such protection. Moreover, certain of our salescontracts provide that we must indemnify our customers against claims by thirdparties for intellectual property rights infringement related to our products.There are no limitations on the maximum potential future payments under theseguarantees. Therefore, we may incur substantial costs related to anyinfringement claim, which may substantially harm our results of operations andfinancial condition.

 

We may, in the future, become subject to litigation to defend againstclaimed infringements of the rights of others or to determine the scope andvalidity of the proprietary rights of others. Future litigation may also benecessary to enforce and protect our trade secrets and other intellectualproperty rights. Any intellectual property litigation or threatenedintellectual property litigation could be costly, and adverse determinations orsettlements could result in the loss of our proprietary rights, subject us tosignificant liabilities, require us to seek licenses from or pay royalties tothird parties which may not be available on commercially reasonable terms, ifat all, and/or prevent us from manufacturing or selling our products, whichcould cause disruptions to our operations.

 

In the event that there is a successful claim of infringement againstus and we fail to develop non-infringing technology or license the proprietyrights on commercially reasonable terms and conditions, our business, resultsof operations or financial condition could be materially and adverselyimpacted.

 

***Ourmultinational operations subject us to various economic, political, regulatoryand legal risks.***

 

We market and sell our products globally, with the majority of oursales made in China. The expansion of our existing multinational operations andentry into new markets will require significant management attention andfinancial resources. Multinational operations are subject to a variety ofrisks, such as:

 

•                                          theburden of complying with a variety of foreign laws and regulations;

 

•                                          theburden of complying with United States laws and regulations for foreignoperations, including the Foreign Corrupt Practices Act;

 

•                                          difficultycomplying with continually evolving and changing global product andcommunications standards

 

43

----

 

and regulations for both our end products andtheir component technology;

 

•                                          marketacceptance of our new products, including longer product acceptance periods innew markets into which we enter;

 

•                                          relianceon local original equipment manufacturers (OEMs), third-party distributors andagents to effectively market and sell our products;

 

•                                          unusualcontract terms required by customers in developing markets;

 

•                                          changesin local governmental control or influence over our customers;

 

•                                          changesto import and export regulations, including quotas, tariffs, licensingrestrictions and other trade barriers;

 

•                                          evolvingand unpredictable nature of the economic, regulatory, competitive and politicalenvironments;

 

•                                          reducedprotection for intellectual property rights in some countries;

 

•                                          longeraccounts receivable collection periods; and

 

•                                          difficultiesand costs of staffing and managing multinational operations, including but notlimited to internal control and compliance.

 

***We do business inmarkets that are not fully developed, which subjects us to various economic,political, regulatory and legal risks unique to developing economies.***

 

Less developed markets present additional risks, such as the following:

 

•                                          customersthat may be unable to pay for our products in a timely manner or at all;

 

•                                          newand unproven markets for our products and the telecommunications services thatour products enable;

 

•                                          inconsistentinfrastructure support;

 

•                                          lackof a large, highly trained workforce;

 

•                                          difficultyin controlling local operations from our headquarters;

 

•                                          variableethical standards and an increased potential for fraud;

 

•                                          unstablepolitical and economic environments; and

 

•                                          alack of a secure environment for our personnel, facilities and equipment.

 

In particular, these factors create the potential for physical loss ofinventory and operating assets. We have in the past experienced cases ofvandalism and armed theft of our equipment that had been or was being installedin the field. If disruptions for any of these reasons become too severe in anyparticular market, it may become necessary for us to terminate contracts andwithdraw from that market and suffer the associated costs and lost revenue.

 

***Weare subject to risks relating to currency rate fluctuations and exchangecontrols.***

 

Because most of our sales are made in foreign countries, we are exposedto market risk for changes in foreign exchange rates on our foreigncurrency-denominated accounts and notes receivable balances. We do notcurrently hedge our foreign currency-denominated transactions. Historically,the majority of our sales have been made in China and denominated in Renminbi.The impact of currency fluctuations of Renminbi thus far has been insignificantas it is fixed to the U.S. dollar.

 

44

----

 

However, in the future, China could choose to devalue the Renminbiversus the U.S. dollar, or the Renminbi-U.S. dollar exchange rate could float,and the Renminbi could depreciate relative to the U.S. dollar. Fluctuations incurrency exchange rates in the future may have a material adverse effect on ourresults of operations.

 

We enter into transactions that may expose us to foreign currency ratefluctuation risk. Historically, the largest component of our foreign currencyexchange loss has resulted from our purchasing inventory denominated in foreigncurrencies. If we continue to purchase inventory in foreign currencies, we mayincur additional foreign currency exchange losses, causing our operatingresults to suffer.

 

Moreover, some of the foreign countries in which we do business mightimpose currency restriction that may limit the ability of our subsidiaries andjoint ventures in such countries to obtain and remit foreign currency necessaryfor the purchase of imported components and may limit our ability to obtain andremit foreign currency in exchange for foreign earnings. For example, Chinaemploys currency controls restricting Renminbi conversion, limiting our abilityto engage in currency hedging activities in China. Various foreign exchangecontrols may also make it difficult for us to repatriate earnings, which couldhave a material adverse effect on our ability to conduct business globally.

 

***Businessinterruptions could adversely affect our business.***

 

Our operations are vulnerable to interruption by fire, earthquake,power loss, telecommunications failure, external interference with ourinformation technology systems, incidents of terrorism and other events beyondour control. For example, our Hangzhou manufacturing facility’s ability toproduce sufficient products is dependent upon a continuous power supply, andthe power required to source our manufacturing operations is inconsistent. TheHangzhou facility has in the past been subject to power shortages, which hasaffected our ability to produce and ship sufficient products. We do not have adetailed disaster recovery plan, and the occurrence of any events like thesethat disrupt our business could harm our operating results.

 

***Wemay suffer losses with respect to equipment held at customer sites, which couldharm our business.***

 

We face the risk of loss relating to our equipment held at customersites. In some cases, our equipment held at customer sites is under contract,pending final acceptance by the customer. We do not hold title or risk of losson such equipment, as title and risk of loss are typically transferred to thecustomer upon delivery of our equipment. However, we do not recognize revenueand accounts receivable with respect to the sale of such equipment until weobtain acceptance from the customer. If we do not obtain final acceptance, wemay not be able to collect the contract price and recover this equipment or itsassociated costs. In other cases, particularly in China, where governmentalapproval is required to finalize certain contracts, inventory not undercontract may be held at customer sites. We hold title and risk of loss on this inventoryuntil the contracts are finalized and, as such, are subject to any lossesincurred resulting from any damage to or loss of this inventory. If ourcontract negotiations fail or if the government of China otherwise delaysapproving contracts, we may not recover or receive payment for this inventory.Moreover, our insurance may not cover all losses incurred if our inventory atcustomer sites not under contracts is damaged prior to contract finalization.If we incur a loss relating to inventory for any of the above reasons, ouroperating results could be harmed.

 

***Wehave been named as a defendant in securities litigation.***

 

We and various underwriters for our initial public offering aredefendants in a purported shareholder class action. The complaint allegesundisclosed improper underwriting practices concerning the allocation of IPOshares, in violation of the federal securities laws. Similar complaints havebeen filed concerning the IPOs of more than 300 companies, and the litigationhas been coordinated in United States District Court for the Southern Districtof New York as In re Initial Public Offering Securities Litigation, 21 MC 92.Although we believe we have valid defenses to the claims against us and intendto defend the litigation vigorously, until the matter is resolved, it will benecessary for us to continue to expend time and financial resources on thematter. Moreover, an adverse judgment in the litigation could materially harmour operations.

 

***Standards for compliance with Section 404 of the Sarbanes-OxleyAct of 2002 are uncertain, and if we fail to comply in a timely manner, ourbusiness could be harmed and our stock price could decline.***

 

We must comply with the rulespromulgated under Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”)by December 31, 2004. Rules describing the requirements for our auditorsto be able to attest to our compliance under Section 404 were adopted inJune, 2004, and we, along with our external service providers, are currentlyinterpreting what qualifies as compliance with Section 404. Because thematter of Section 404 compliance is new, there is no precedent or provenmethod for such compliance, and our management must exercise significantjudgment in our effort to comply with

 

45

----

 

Section 404. As a result of this uncertainty, we cannot be certainthat we will comply with the requirements of Section 404 in a timelymanner. If we fail to comply in a timely manner, public perception of ourinternal controls could be damaged, causing our financial results to suffer andour stock price to decline.

 

***Recentlyenacted and proposed changes in securities laws and regulations are likely toincrease our costs.***

 

The Sarbanes-Oxley Act of 2002 has required and will continue torequire changes in some of our corporate governance and securities disclosureor compliance practices. That Act also requires the SEC to promulgate new ruleson a variety of subjects, in addition to rule proposals already made, and TheNasdaq National Market has revised its requirements for companies that areNasdaq-listed. We expect these developments (i) will require us to devoteadditional resources to our operational, financial and management informationsystems procedures and controls to ensure our continued compliance with currentand future laws and regulations, (ii) will make it more difficult and moreexpensive for us to obtain director and officer liability insurance, and we maybe required to accept reduced coverage, increase our level of self-insurance,or incur substantially higher costs to obtain coverage, and (iii) could make itmore difficult for us to attract and retain qualified members of our board ofdirectors, or qualified executive officers. We are presently evaluating and monitoringregulatory developments and cannot estimate the timing or magnitude ofadditional costs we may incur as a result.

 

***Changes inaccounting rules.***

 

Weprepare our financial statements in conformity with accounting principlesgenerally accepted in the United States of America. These principles aresubject to interpretation by the Securities and Exchange Commission and variousbodies formed to interpret and create appropriate accounting policies. A changein these policies can have a significant effect on our reported results and mayeven retroactively affect previously reported transactions. In particular,changes to Financial Accounting Standards Board (FASB) guidelines relating toaccounting for stock-based compensation will likely increase our compensationexpense, could make our net income less predictable in any given reportingperiod and could change the way we compensate our employees or cause otherchanges in the way we conduct our business.

 

**RISKS RELATED TO CONDUCTING BUSINESS IN CHINA**

 

***China’sgovernmental and regulatory reforms may impact our ability to do business inChina.***

 

The Chinese government, through the Ministry of Information Industry,the Chinese telecommunication industry’s regulating body, has broad discretionand authority over all aspects of the telecommunications and informationtechnology industry in China, with the power to permit or prohibit the sales ofany of our products. Since 1978, the Chinese government has been in a state ofevolution and reform. The reforms have resulted in and are expected to continueto result in significant economic and social development in China. Many of thereforms are unprecedented or experimental and may be subject to change orreadjustment due to a variety of political, economic and social factors. Whilewe anticipate that the basic principles underlying the reforms will remainunchanged, any of the following changes in China’s political and economicconditions and governmental policies could have a substantial impact on ourbusiness:

 

•                                          thepromulgation of new laws and regulations and the interpretation of those lawsand regulations;

 

•                                          inconsistentenforcement and application of the telecommunications industry’s rules andregulations by the Chinese government between foreign and domestic companies;

 

•                                          theintroduction of measures to control inflation or stimulate growth;

 

•                                          theintroduction of new guidelines for tariffs and service rates, which affect ourability to competitively price our products and services;

 

•                                          changesin the rate or method of taxation;

 

•                                          theimposition of additional restrictions on currency conversion and remittancesabroad; or

 

•                                          anyactions which limit our ability to develop, manufacture, import or sell ourproducts in China, or to finance

 

46

----

 

and operate our business in China.

 

For example, in the year 2000, the Ministry of Information Industrytemporarily halted deployment of our PAS systems and handsets, pending itsreview of personal handyphone system (“PHS”)-based telecommunicationsequipment, a microcellular wireless communications technology. The Ministry ofInformation Industry later allowed the continued deployment of PHS-basedsystems, such as our PAS systems and handsets, in China’s county-level cities,towns and villages but limited deployments within large and medium-sized citiesto very limited areas of dense population, such as campuses, commercialbuildings and special development zones. If in the future the Ministry ofInformation Industry determines to prohibit the sale or deployment of our PASsystems and handsets or our other products, or if it imposes additionallimitations on their sale, our business and financial condition could suffer.

 

In addition to modifying the existing telecommunications regulatory framework,the Chinese government is currently preparing a draft of a standard, nationaltelecommunications law (the “Telecommunications Law”) to provide a uniformregulatory framework for the telecommunications industry. We do not yet knowthe final nature or scope of the regulation that would be created if theTelecommunications Law is passed. Accordingly, we cannot predict whether itwill have a positive or negative effect on us or on some or all aspects of ourbusiness.

 

***China’schanging economic environment may impact our ability to do business in China.***

 

Since 1978, the Chinese government has been reforming the economicsystem in China to increase emphasis placed on decentralization and theutilization of market forces in the development of China’s economy. Thesereforms have resulted in significant economic growth. However, any economicreform policies or measures in China may from time to time be modified orrevised by the Chinese government. While we may be able to benefit from theeffects of some of these policies, these policies and other measures taken bythe Chinese government to regulate the economy could also have a significantnegative impact on economic conditions in China, which would result in anegative impact on our business. More recently, China’s economic environmenthas been changing as a result of China’s entry into the World TradeOrganization (WTO), which was effective in December of 2001. Entry intothe WTO requires that China reduce tariffs and eliminate non-tariff barriers, includingquotas, licenses and other restrictions, by 2005 at the latest, and we cannotpredict the impact of these changes on China’s economy. Moreover, althoughChina’s entry into the WTO and the related relaxation of trade restrictions maylead to increased foreign investment, it may also lead to increased competitionin China’s markets from other foreign companies. If China’s entry into the WTOresults in increased competition or has a negative impact on China’s economy,our business could suffer. In addition, although China is increasinglyaccording foreign companies and foreign investment enterprises established inChina the same rights and privileges as Chinese domestic companies as a resultof its admission into the WTO, special laws, administrative rules andregulations governing foreign companies and foreign investment enterprises inChina may still place foreign companies at a disadvantage in relation toChinese domestic companies and may adversely affect our competitive position.

 

***Uncertaintieswith respect to the Chinese legal system may adversely affect us.***

 

We conduct our business in China primarily through our wholly-ownedsubsidiaries incorporated in China. Our subsidiaries are generally subject tolaws and regulations applicable to foreign investment in China. Accordingly,our business might be affected by China’s developing legal system. Since 1978,many new laws and regulations covering general economic matters have beenpromulgated in China, and government policies and internal rules promulgated bygovernmental agencies may not be published in time, or at all. As a result, wemay operate our business in violation of new rules and policies without havingany knowledge of their existence. In addition, there are uncertaintiesregarding the interpretation and enforcement of laws, rules and policies inChina. The Chinese legal system is based on written statutes, and prior courtdecisions have limited precedential value. Because many laws and regulationsare relatively new and the Chinese legal system is still evolving, theinterpretations of many laws, regulations and rules are not always uniform.Moreover, the relative inexperience of China’s judiciary in many cases createsadditional uncertainty as to the outcome of any litigation, and the interpretationof statutes and regulations may be subject to government policies reflectingdomestic political changes. Finally, enforcement of existing laws or contractsbased on existing law may be uncertain and sporadic, and it may be difficult toobtain swift and equitable enforcement, or to obtain enforcement of a judgmentby a court of another jurisdiction. Any litigation in China may be protractedand result in substantial costs and diversion of resources and managementattention.

 

***Weonly have trial licenses to sell certain of our network access products inChina.***

 

Under China’s current regulatory structure, the communications productsthat we offer in China must meet government and industry standards, and anetwork access license for the equipment must be obtained. Without a license,telecommunications equipment is not allowed to be connected to publictelecommunications networks or sold in China. Moreover, we must ensure that thequality of the telecommunications equipment for which we have obtained anetwork access license is stable and reliable,

 

47

----

 

and will not lower the quality or performance of other installedlicensed products. China’s State Council’s product quality supervisiondepartment, in concert with China’s Ministry of Information Industry, performsspot checks to track and supervise the quality of licensed telecommunicationsequipment and publishes the results of such spot checks.

 

We have obtained a probationary network access license for our mSwitchproduct, and after the trial period, we anticipate that an official networkaccess license will be issued if the trial demonstrates that mSwitch satisfiesall the applicable government and industry standards. However, we cannot becertain that we will receive this license. Moreover, we only have triallicenses for our PAS systems and handsets. We have applied for, but have notyet received, a final official network access license for our PAS systems andhandsets. Based upon conversations with China’s Ministry of InformationIndustry, we understand that our PAS systems and handsets are considered tostill be in the trial period and that sales of our PAS systems and handsets maycontinue to be made by us during this trial period, but that a license will ultimatelybe required. If we fail to obtain the required licenses, we could be prohibitedfrom making further sales of the unlicensed products, including our PAS systemsand handsets, in China, which would substantially harm our business, financialcondition and results of operations. The regulations implementing theserequirements are not very detailed, have not been applied by a court and may beinterpreted and enforced by regulatory authorities in a number of differentways. Our counsel in China has advised us that China’s governmental authoritiesmay interpret or apply the regulations with respect to which licenses arerequired and the ability to sell a product while a product is in the trialperiod in a manner that is inconsistent with the information received by ourcounsel in China, and either of these conditions could have a material adverseeffect on our business, financial condition and results of operations.

 

***If China TelecomCorporation (“China Telecom”)**or China Netcom International Corporation Ltd.(“China Netcom”) obtains licenses allowing them to deliver mobile services, ourability to sell our PAS mobile systems and handsets could be impaired.***

 

China Telecom and China Netcom hold and operate the fixed linetelephone and data communications assets in China, and currently do not havethe licenses necessary to offer mobile services. However, China’s media sourceshave widely reported that China’s Ministry of Information Industry may grantmobile licenses to China Telecom or China Netcom, or to both toward the end of2004. Furthermore, it is anticipated that the mobile license granted by thegovernment will be used for 3G mobile network deployments.

 

If China Telecom or China Netcom obtain 3G mobile licenses, they maydirect capital expenditures to build-out 3G networks, and capital expendituresto build-out PAS networks that utilize our existing products may decline.Moreover, they may elect not to deploy our PAS systems and handsets or othermobile services that we may offer in the future. In addition, it is possiblethat current PAS frequency bands utilized by PAS networks may be reallocatedfor use by 3G networks, which would have the effect of restricting or shuttingdown PAS networks. If this were to occur, we could lose current and potentialfuture customers for our products, and our financial condition and results ofoperations could be significantly harmed.

 

***Promotional orincentive programs offered by mobile operators such as China Mobile and ChinaUnicom may adversely impact the competitiveness and pricing of our PAS systemsand related products.***

 

The official tariffs and per-minute usage rates charged to mobile usersin China are generally set by the Ministry of Information Industry and theNational Development and Reform Commission, and are usually adhered to bymobile operators. However, from time to time, certain mobile operators such asChina Mobile and China Unicom have offered special promotional pricing orincentives to customers, such as free incoming calls or free mobile-to-mobilecalls. The continued use of such incentive programs by mobile operators mayadversely impact the competitiveness and pricing of our PAS systems and relatedproducts and their rollout by the new China Telecom and China Netcom. Suchincentive programs may continue or be expanded in the future. We cannot becertain as to what impact such incentive programs may have on our financialcondition. However, it is possible that the continuation or expansion of suchprograms may have a material adverse effect on our business or results ofoperations.

 

***Iftax benefits available to our subsidiaries located in China are reduced orrepealed, our business could suffer.***

 

The Chinese government is considering the imposition of a “unified”corporate income tax that would phase out, over time, the preferential taxtreatment to which foreign investment enterprises, such as our company, arecurrently entitled. While it is not certain whether the government willimplement such a unified tax structure or whether our company will be grandfatheredinto any new tax structure, if a new tax structure is implemented, a new taxstructure may adversely affect our financial condition. Moreover, certain ofour subsidiaries and joint ventures located in China enjoy tax benefits inChina that are generally available to foreign investment enterprises. If thesetax benefits are reduced or repealed due to changes in tax laws, our businesscould suffer. We are currently applying for the ability to share research anddevelopment costs among our key worldwide entities.  This is a new concept in China, and we areworking closely with the China Tax and Regulatory Authorities to gain approvalfor this cost sharing. If the cost sharing is not approved by China, oureffective tax rate may increase.

 

48

----

 

**RISKS RELATED TO OUR STOCK PERFORMANCE AND**

**CONVERTIBLE DEBT SECURITIES**

 

***Ourstock price is highly volatile.***

 

The trading price of our common stock has fluctuated significantlysince our initial public offering in March of 2000. Our stock price couldbe subject to wide fluctuations in the future in response to many events orfactors, including those discussed in the preceding risk factors relating toour operations, as well as:

 

•                                          actualor anticipated fluctuations in operating results, actual or anticipated grossprofit as a percentage of net sales, levels of inventory, our actual oranticipated rate of growth and our actual or anticipated earnings per share;

 

•                                          changesin expectations as to future financial performance or changes in financialestimates or buy/sell recommendations of securities analysts;

 

•                                          changesin governmental regulations or policies in China, such as the temporarysuspension of sales of our PAS systems that occurred in May and June of2000, which caused our stock price to drop;

 

•                                          our,or a competitor’s, announcement of new products, services or technologicalinnovations;

 

•                                          theoperating and stock price performance of other comparable companies; and

 

•                                          newsand commentary emanating from the media, securities analysts or governmentbodies in China relating to us and to the industry in general.

 

General market conditions and domestic or international macroeconomicfactors unrelated to our performance may also affect our stock price. For thesereasons, investors should not rely on recent trends to predict future stockprices or financial results. In addition, following periods of volatility in acompany’s securities, securities class action litigation against a company issometimes instituted. This type of litigation could result in substantial costsand the diversion of management time and resources.

 

In addition, public announcements by China Telecom and China Netcom,each of which exert significant influence over many of our major customers inChina, may contribute to volatility in the price of our stock. In 2002, ChinaTelecom completed its initial public offering, which has caused that entity toissue press releases more frequently than in prior years. The price of ourstock may react to such announcements. More recently, it has been reported thatChina Netcom has been restructuring its operations for its own initial publicoffering. More frequent public announcements from China Netcom relating to orresulting from their initial public offering could cause the price of our stockto become even more volatile.

 

***SOFTBANK CORP. andits related entities, including SOFTBANK America Inc., have significantinfluence over our management and affairs, which it could exercise against yourbest interests.***

 

SOFTBANK CORP. and its related entities, including SOFTBANKAmerica Inc. (collectively, “SOFTBANK”), beneficially owned approximately12.9% of our outstanding stock as of June 30, 2004. As a result, SOFTBANKhas the ability to influence all matters submitted to our stockholders forapproval, as well as our management and affairs. Matters that could requirestockholder approval include:

 

•                                          electionand removal of directors;

 

•                                          mergeror consolidation of our company; and

 

•                                          saleof all or substantially all of our assets.

 

This concentration of ownership may delay or prevent a change ofcontrol or discourage a potential acquirer from making a tender offer orotherwise attempting to obtain control of our company, which could decrease themarket price of our common stock.

 

49

----

 

***Delaware law and ourcharter documents contain provisions that could discourage or prevent apotential takeover, even if the transaction would benefit our stockholders.***

 

Other companies may seek to acquire or merge with us. An acquisition ormerger of our company could result in benefits to our stockholders, includingan increase in the value of our common stock. Some provisions of ourCertificate of Incorporation and Bylaws, as well as provisions of Delaware law,may discourage, delay or prevent a merger or acquisition that a stockholder mayconsider favorable. These provisions include:

 

•                                          authorizingthe board of directors to issue additional preferred stock;

 

•                                          prohibitingcumulative voting in the election of directors;

 

•                                          limitingthe persons who may call special meetings of stockholders;

 

•                                          prohibitingstockholder action by written consent;

 

•                                          creatinga classified board of directors pursuant to which our directors are elected forstaggered three year terms; and

 

•                                          establishingadvance notice requirements for nominations for election to the board ofdirectors and for proposing matters that can be acted on by stockholders atstockholder meetings.

 

***Theholders of our convertible subordinated notes due in 2008 and we face a varietyof risks related to the notes.***

 

Holders of our convertible subordinated notes due 2008 (the “notes”)and we face a variety of risks with respect to the notes, including thefollowing:

 

•                                          wemay be limited in our ability to purchase the notes in the event of a change incontrol, either for cash or stock, which could result in our defaulting on thenotes at the time of the change in control and purchases for stock would besubject to market risk;

 

•                                          anevent of default under our senior debt, including one of our subsidiaries,could restrict our ability to purchase or pay any or all amounts due on notes,and after paying our senior debt in full, we may not have sufficient assetsremaining to pay any or all amounts due on the notes;

 

•                                          thereis no listed trading market for the notes, which could have a negative impacton the market price of the notes;

 

•                                          wehave significantly increased our leverage as a result of the sale of the noteswhich could have an adverse impact on our ability to obtain additionalfinancing for working capital;

 

•                                          hedgingtransactions related to the notes and our common stock and other transactions,as well as changes in interest rates and our creditworthiness, may affect thevalue of the notes and of our common stock; and

 

•                                          thenotes might not be rated or may receive a lower rating than anticipated byinvestors, ultimately having a negative affect on the price of the notes and ofour common stock.

 

**ITEM3****—QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS**

 

We are exposed to the impact of interest rate changes, changes inforeign currency exchange rates and changes in the stock market.

 

*Interest Rate Risk.*  Our exposure to market risk for changes ininterest rates relates primarily to our investment

 

50

----

 

portfolio. The fair value of our investment portfolio would not besignificantly affected by either a 10% increase or decrease in interest ratesdue mainly to the short-term nature of most of our investment portfolio.However, our interest income can be sensitive to changes in the general levelof U.S. interest rates since the majority of our funds are invested ininstruments with maturities less than one year. Our policy is to limit the riskof principal loss and ensure the safety of invested funds by generallyattempting to limit market risk. Funds in excess of current operatingrequirements are mostly invested in government-backed notes, commercial paper,floating rate corporate bonds, fixed income corporate bonds and tax-exemptinstruments. In accordance with our investment policy, all short-terminvestments are invested in “investment grade” rated securities with minimum Aor better ratings. Currently, most of our short-term investments have AA orbetter ratings.

 

The table below represents carrying amounts and relatedweighted-average interest rates of our investment portfolio at June 30,2004:

 
| **(in  thousands except interest rates)** | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|------------|------------|
|                                      |       |       |       |
| Cash and cash equivalents                 |       | $          | 484,767    |   |
| Average interest rate                     |       | 0.95       | %          |
| Restricted cash                           |       | 15,249     |       |
| Average interest rate                     |       | 0.51       | %          |
| Restricted short-term investments         |       | 27,384     |       |
| Average interest rate                     |       | 1.04       | %          |
| Short-term investments                    |       | 76,979     |       |
| Average interest rate                     |       | 1.39       | %          |
| Total investment securities               |       | $          | 604,379    |   |
| Average interest rate                     |       | 1.002      | %          |
|                                           |            |            |            |  |  |

 

*Concentration of Credit Risk and MajorCustomers:*The table below outlines our sales to, andthe accounts receivable balances with respect to our largest customers:

 
| **For the three months ended June 30,** | ** ** | **For the six months ended June 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| **2004**                                     | ** ** | **% of Net  Sales**                        | ** ** | **% of  Accounts  Receivable** | ** ** | **2004** | ** ** | **% of Net  Sales** | ** ** | **% of  Accounts  Receivable** | ** ** |
| B                                            |       | 15%                                        |       | 15% |   | A |   | 16% |   | 9% |   |
| C                                            |       | 10%                                        |       | 14% |   | B |   | 11% |   | 15% |   |
|                                         |       |                                       |       |   |   | C |   | 10% |   | 14% |   |
|                                         |       |                                       |       |   |   |   |   |   |   |   |   |
| **2003**                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** | ** ** | ** ** |
| C                                            |       | 13%                                        |       | 7% |   | C |   | 13% |   | 7% |   |
| D                                            |       | 11%                                        |       | 9% |   |   |   |   |   |   |   |
| E                                            |       | 10%                                        |       | 5% |   |   |   |   |   |   |   |

 

The Company extends credit to its customers in China generally withoutrequiring collateral. In global sales outside of China, the Company oftenrequires letters of credit from its customers. The Company monitors its exposurefor credit losses and maintains allowances for doubtful accounts.

 

*Foreign Exchange Rate Risk.*  We are exposed to foreign currency exchangerate risk because most of our sales in China are denominated in Renminbi. Dueto the limitations on converting Renminbi, we are limited in our ability toengage in foreign currency hedging activities in China.  Beginning in the first quarter of 2004, wehedge certain Japanese Yen-denominated balance sheet exposures against futuremovements in foreign currency exchange rates by using foreign currency forwardcontracts. Gains and losses on these fair value hedges are intended to offsetgains and losses from the revaluation of our Japanese Yen-denominatedrecognized liabilities. In accordance with Statement of Financial AccountingStandards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments andHedging Activities,” we recognize derivative instruments and hedging activitiesas either assets or liabilities on the balance sheet and measure them at fairvalue. The net result of gains and losses on contracts and revaluation includedin interest and other income (expense) was insignificant for the three and sixmonths ended June 30, 2004. Our foreign currency forward contractsgenerally mature within three months. We do not intend

 

51

----

 

to utilize derivative financial instruments for trading purposes. Therewere no foreign currency forward contracts held at June 30, 2004.Movements in currency exchange rates could cause variability in our otherincome (expense).

 

Although the impact of currency fluctuations of Renminbi to date hasbeen insignificant, fluctuations in foreign currency exchange rates in thefuture may have a material adverse effect on our results of operations. Wemaintain a bank account in Japanese Yen for purchasing portions of ourinventories and supplies. The balance of this Japanese Yen account as ofJune 30, 2004 was approximately $36.7 million.

 

**ITEM 4****—CONTROLS AND PROCEDURES**

 

During thepreparation of the Company's Quarterly Report on Form 10-Q, an equipment saletransaction was identified in a single geographical sales market, outside ofChina, in the amount of approximately $1.9 million that was initially includedas revenue in the Company's proposed internal draft financial statements forthe second quarter.  Upon furtheranalysis, it was determined that this transaction did not qualify asrecognizable revenue and as such, the Company did not include such revenue inthe financial statements for the quarter ended June 30, 2004.

 

Uponidentification of this matter, management and the audit committee initiated afull review and analysis of the facts and circumstances surrounding thistransaction.  No additional discrepancieswere noted related to the recording or reporting of revenue.  The findings of this review have ledmanagement to conclude that certain significant control deficiencies existrelated to the review and evaluation of criteria related to revenuerecognition, including process deficiencies with respect to obtaining evidenceof delivery.

 

In connectionwith the above findings and in an effort to address the weaknesses identifiedin the Company’s internal controls, management has determined that it will takeimmediate corrective actions.  Suchactions will include:

 

•      a centralized review, analysis and controlof all non-China revenue recognition by U.S. corporate management, includingreceipt of 3rd party evidence of delivery and final acceptance certificateissued by the customer;

•      limitations of local signature approvalauthority for signing contracts; and

 

•      additional reconciliation and review ofcustomer site inventory balances.

 

Separate fromthe review, the Company discovered that certain inventory transactions recordedin the quarter ended June 30, 2004 were in error.  The Company recorded an adjustment reflectedin the Financial Statements to increase inventory and decrease cost of sales by$0.8 million for the three and six months ended June 30, 2004 and to increaseearnings per share by $0.01.

 

In addition,the Company is undertaking a thorough review of its internal controls as partof the Company’s preparation for compliance with the requirements of Section404 of the Sarbanes-Oxley Act of 2002. Rules describing the requirements for the Company's independent auditorsto be able to attest to our compliance under Section 404 were adopted in June2004 and we, along with our external service providers, are currentlyinterpreting compliance requirements under Section 404.  As a result of this uncertainty, as well asthe significant control deficiencies noted above, the Company cannot be certainthat we will be able to comply with the requirements of Section 404 by theDecember 31, 2004 deadline.

 

Ourmanagement, including the Chief Executive Officer and the Chief FinancialOfficer, has conducted an evaluation of the effectiveness of the design andoperation of our disclosure controls and procedures, pursuant to Exchange ActRule 13a-15(e) and 15d-15(e) as of June 30, 2004.  Based on thatevaluation, combined with a consideration of the additional proceduresdescribed above, the Chief Executive Officer and the Chief Financial Officerconcluded that, notwithstanding the significant control weakness describedabove, our disclosure controls and procedures are effective in ensuring thatall material information required to be disclosed in this quarterly report hasbeen made known to them in a timely fashion and no changes are required at thistime.

 

In connection with the evaluation by our management, including theChief Executive Officer and Chief Financial Officer, of our internal controlover financial reporting, except as noted above, no changes during the quarterended June 30, 2004 were identified that have materially affected or are reasonablylikely to materially affect our internal control over financial reporting.

 

 

**PARTII—OTHER INFORMATION**

 

**ITEM1—LEGAL PROCEEDINGS**

 

On October 31,2001, a complaint was filed in United States District Court for the SouthernDistrict of New York against us, some of its directors and officers and variousunderwriters for its initial public offering. Substantially similar actionswere filed concerning the initial public offerings for more than 300 differentissuers, and the cases were coordinated as *Inre Initial Public Offering Securities Litigation*, 21 MC 92. In April2002, a consolidated amended complaint was filed in the matter against us,captioned *In re UTStarcom, Initial PublicOffering Securities Litigation*, Civil Action No. 01-CV-9604.Plaintiffs allege violations of the Securities Act of 1933 and the SecuritiesExchange Act of 1934 through undisclosed improper underwriting practicesconcerning the allocation of IPO shares in exchange for excessive brokeragecommissions, agreements to purchase shares at higher prices in the aftermarket,and misleading analyst reports. Plaintiffs seek unspecified damages on behalfof a purported class of purchasers our common stock between March 2, 2000 andDecember 6, 2000. Our directors and officers were dismissed without prejudicepursuant to a stipulation. On February 19, 2003, the Court granted in part anddenied in part a motion to dismiss brought by defendants including us. Theorder dismissed all claims against us except for a claim brought under Section 11of the Securities Act of 1933, which alleges that our initial public offeringregistration statement contained untrue statements of material fact and omittedto state material facts required to be stated in the registration statement, ornecessary to make the statements therein not misleading.

 

In June 2004, a stipulationof settlement and release of claims against the issuer defendants, includingus, was submitted for preliminary approval by the Court. Under the settlement,the plaintiffs would dismiss and release all claims against participatingdefendants in exchange for a contingent payment undertaking by the insurancecompanies collectively responsible for insuring the issuer defendants in thecoordinated action, and the assignment or surrender to the plaintiffs ofcertain claims the issuer defendants may have against the underwriters.Pursuant to the undertaking, the insurers would be required to pay the amount,if any, by which $1.0 billion exceeds the total amount ultimately collected bythe plaintiffs from the non-settling defendants in the coordinated action. Thesettlement is subject to a number of conditions including Court approval. 

 

If the settlement does notoccur, and litigation against UTStarcom continues, we believe it has validdefenses and intends to defend the case vigorously. We are unable to currentlyestimate the loss, if any, associated with the above litigation.

 

We have fileda patent infringement suit against Starent Networks Corporation (“Starent”) inthe U.S. District Court for the Northern District of California.  In its Complaint, we assert that Starentinfringes two UTStarcom patents through the manufacture, offer for sale, andsale of Starent’s ST-16 Intelligent Mobile Gateway.  On June 3, 2004, we served our complainton Starent.  On July 30, 2004,Starent filed and served its answer and counterclaims.  In its counterclaims, Starent asserts thatthe patents are not infringed, are invalid, and are unenforceable and assertsunfair competition against us.  The Courtis scheduled to hold an initial case management conference on October 12,2004.  Although we cannot reliablypredict the outcome of this litigation, it believes that any liability arisingfrom Starent’s counterclaims will not have a material adverse effect on thebusiness, financial condition, or results of our operations.

 

We are a party to other litigation matters and claims that are normalin the course of our operations, and while the results of such litigationmatters and claims cannot be predicted with certainty, we believe that thefinal outcome of such matters will not have a material adverse impact on ourfinancial position or results of operations.

 

52

----

 

**ITEM2—CHANGES IN SECURITIES, USE OF PROCEEDS ANDISSUER PURCHASES OF EQUITYSECURITIES**

 

(e) Stock repurchased for the quarter ended June 30, 2004 is asfollows:

 
| **Period**                               | ** ** | **Total Number  of shares  purchased (1)** | ** ** | **Average  purchase price  per share** | ** ** | **Total Number of shares  purchased as part of a publicly  announced program (1)** | ** ** | **Maximum number of shares  that may yet be purchased  under the repurchase plan** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
|                                     |       |                                       |       |                                   |       |                                                                               |       |                                                                               |       |
| April 1, 2004 - April 30, 2004 |       | 987,566                                    |       | $                                      | 29.79      |                                                                               | 987,566    |                                                                               | 3,067,434  |   |
|                                     |       |                                       |       |                                   |       |                                                                               |       |                                                                               |       |
| May 1, 2004 - May 31, 2004               |       | —                                     |       | —                                 |       | —                                                                             |       | 3,067,434                                                                          |       |
|                                     |       |                                       |       |                                   |       |                                                                               |       |                                                                               |       |
| June 1, 2004 - June 30, 2004   |       | —                                     |       | —                                 |       | —                                                                             |       | 3,067,434                                                                          |       |
| Total                                    |       | 987,566                                    |       |                                   |       | 987,566                                                                            |       | 3,067,434                                                                          |       |
|                                          |            |                                            |            |                                        |            |                                                                                    |            |                                                                                    |            |  |

 

----

(1)**         **On March 12,2004, the Company announced a program to repurchase up to 5,000,000 shares of its outstanding commonstock over a period of six months, until September, 2004 (the “RepurchaseProgram”).

 

**ITEM 3—DEFAULTSUPON SENIOR SECURITIES**

 

[None.]

 

**ITEM 4—SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

On May 14, 2004, the Company held its annual meeting ofstockholders.  As ofMarch 29, 2004, the record date for the annual meeting, there were117,198,949 shares of common stock of the Company issued and outstanding andentitled to vote at the annual meeting. The following proposals were submitted to a vote of the stockholders:

 

(i)                                     Toelect the following two Class I members currently serving on the Board ofDirectors to serve until the date on which the annual meeting of stockholdersis held in the year 2007.

 
| **Election  of Directors** | ** ** | **Votes for** | ** ** | **Votes Withheld** |
|----------------------------|------------|---------------|------------|--------------------|
| Thomas J. Toy              |       |          | 97,292,989 |               |   | 1,806,649 |
| Ying Wu                    |       |          | 84,582,857 |               |   | 14,516,781 |

 

As a result, Messrs. Toy and Wu were elected as Directors of theCompany.  

 

53

----

 

(ii)                                  Toratify and approve the appointment of PricewaterhouseCoopers LLP as theindependent public accountants of the Company for the fiscal year endingDecember 31, 2004

 
| **For** | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-votes** | ** ** |
|---------|------------|-------------|------------|-------------|------------|----------------------|------------|
|    | 97,242,212 |        |       | 1,775,213   |       |                 | 82,213     |   |   | — |   |
|         |            |             |            |             |            |                      |            |  |  |  |  |

 

**ITEM 5****—OTHER INFORMATION**

 

Our directors, officers, or employees have entered, and may from time totime enter, into good faith trading plans pursuant to SEC Rule 10b5-1(c).

 

54

----

 

**ITEM 6****—EXHIBITS AND REPORTS ON FORM 8-K**

 

(a)                                  Exhibits:

 
| **NUMBER** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                                                                                               |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.100     |       | Asset  Purchase Agreement among UTStarcom, Inc., Telos Technology, Inc., Telos  Technology (Canada), Inc., Telos Technology (Bermuda) Ltd. and Telos  Engineering Limited dated April 21, 2004                                                   |
| 10.101     |       | Asset  Purchase Agreement by and among Audiovox Communications Corp., Quintex Mobile  Communications Corporation, Audiovox Communications Canada Co., UTStarcom,  Inc., UTStarcom Canada Company and Audiovox Corporation, dated as of June 11,  2004 |
| 31.1       |       | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                              |
| 31.2       |       | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                              |
| 32.1       |       | Certification  Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                              |

 

----

(b)                                 Reportson Form 8-K:

 

1.               Report on Form 8-Kdated on April 22, 2004 (filed on April 23, 2004) under Item 5, relatingto the Company’s press release entitled “UTStarcom Agrees to Acquire TELOSTechnology, Leading Provider of Industry-Proven Packet Core Networks for CDMA2000.” 

 

2.               Report on Form 8-Kdated and filed on April 27, 2004 under Item 5 and Item 7, relating to theCompany announcing its results of operation for the first quarter of 2004.

 

3.               Report on Form 8-Kdated and filed on June 14, 2004 under Item 5 and Item 7, relating to theCompany’s press release entitled “UTStarcom Agrees to Acquire Select Assets ofAudiovox Handset Division for $165.1 Million.” 

 

55

----

 

**UTSTARCOM, INC.**

 

**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                             | UTSTARCOM, INC. |
|----------------------------------|-----------------|
|                             |            |
|                             |            |
| Date:  August 16, 2004      | By:             | /s/  Hong Liang Lu |
|                             |            |   |
|                             |            | Hong Liang  Lu |
| * *                         | * *        | *President, Chief Executive Officer and Director* |
| * *                         | * *        | *(Principal Executive Officer)* |
| * *                         | * *        | * * |
| * *                         | * *        | * * |
| * *                         | * *        | * * |
| * *                         | * *        | * * |
| Date:  August 16, 2004 | By:             | /s/  Michael J. Sophie |
|                             |            |   |
|                             |            | Michael J.  Sophie |
| * *                         | * *        | *Senior Vice President of Finance and Chief Financial Officer* |
| * *                         | * *        | *(Principal Financial Officer)* |

 

56

----

 

**UTSTARCOM, INC.**

**EXHIBITINDEX**

 
| **NUMBER** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                                                                                               |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.100     |       | Asset  Purchase Agreement among UTStarcom, Inc., Telos Technology, Inc., Telos  Technology (Canada), Inc., Telos Technology (Bermuda) Ltd. and Telos  Engineering Limited dated April 21, 2004                                                   |
| 10.101     |       | Asset  Purchase Agreement by and among Audiovox Communications Corp., Quintex Mobile  Communications Corporation, Audiovox Communications Canada Co., UTStarcom,  Inc., UTStarcom Canada Company and Audiovox Corporation, dated as of June 11,  2004 |
| 31.1       |       | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                              |
| 31.2       |       | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                              |
| 32.1       |       | Certification  Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                              |

 

----